Investment masterclass: fight against your instinct to make a profit

Blog 5:behavioral finance

James Montier, strategist at GMO has written a book The Little Book of Behavioural Investing: How Not to Be Your Own Worst Enemy.

In behavioral finance we import sights form psychology to the world of finance. It says that most of the investing decisions are taking by emotions than by logic thinking. By understanding this behavior we can learn to avoid it. This is a new way of investing and is grabbing more attention.

1. The narrative fallacy
Investors are easily won by positive stories however the company may be to expensive and creating bubbles. They still keep investing in it because in the past the company did well.
You should focus on the facts instead of on the past.

2. Overconfidence
When investors had a good run they will have more confidence in their abilities. Like in a casino people who have won will bet more reckless than with their own money.
People should have a discipline to avoid this and stick to their investment budget.

3. Following forecasts
Forecasts are more confident than normal investors and we will follow them blindly even though they are sometimes wrong.
According to James Montier we should ignore these people and their forecasts.

4. Information overload
Some people think that you can beat the market when you have more information than the rest but studies shows that excess information can lead to overconfidence as it makes it difficult to distinguish noise from news.
We should better analyze a few things than try to know everything about an investment.

5. Denial
Investors give more weight to information that appeals to them. Try to look for evidence that your own analyze is wrong.

6. Loss aversion
We often sell a stock that has done well than one that has a bad day. To overcome this we should put a sell and buy target and keep to it.

7. Groupthink
We always buy stocks that the herd buys although we pay these stocks often too expensive. We should better go against the herd and search cheap stocks but it’s difficult to go against the herd.

8. Focusing on outcomes
When decisions are taken on outcomes investors avoid uncertainty. Instead they should focus on the process by which they invest, that’s the only thing we can control.

9. Leave the herd behind and go ahead
This is one of the key’s of financial behavior. Investors are always following the herd, they buy hot stuff on the market although we have seen that is often wrong. We had the technical bubble in the late 1990s and the housing bubble in 2009-2010.
People should search for new shares with a positive future look and invest in these.

I agree generally with his statements about investors although i have some remarks with some of his statements. On the narrative fallacy I agree that you must look at the present but you always must look to the past. The company may have had a bad year dude to a wrong investment or a loss of a big client. The future maybe again hopeful after that bad year

Overconfidence is something that occurs to every one of us. Like James Montier says we should have a discipline to avoid this. According to my opinion we should follow forecasts. These persons have the experience and give useful information. It’s possible that it’s wrong but I think that is an exception.

Information overload is hard to find out. Montier is correct that too much information is difficult to distinguish news from noise but when do we have enough information to decide if that investment is a good investment. On the fifth point that tells about denial is may be correct although I don’t really know if investors will do that. It seems to me that they only use information that supports their opinion. You always have to investigate if your information is correct.

According to my opinion it is correct what is told in the point about loss aversion. We all have difficulties with admitting that we have made the wrong decision. If we build a certain target en keep to it, it will help us to conquer that feeling. This may be correct because when we buy something and is bought by the herd we have a kind of certainty that our investment is safe. The opinion of Montier according to the groupthink is also correct that we often buy these stocks to expensive and we better start searching for other cheaper stock with the same return.

On the eighth point I agree that we only may invest in stocks of companies were we are sure that our invested money is safe. Investing on a base of information that is not correct is always a risk. The last point is hardly the same as the seventh point and you must always look for other stocks that are cheap and give a good return.

Source: http://www.timesonline.co.uk/tol/money/investment/article7060010.ece