Description
Book SynopsisBehavioural investing seeks to bridge the gap between psychology and investing. All too many investors are unaware of the mental pitfalls that await them. Even once we are aware of our biases, we must recognise that knowledge does not equal behaviour.
Trade Review"It is quite simply the best and most comprehensive treatment of the subject to date." (
Financial Times, Monday 3rd December 2007)
"The Year's most exhaustive, and often entertaining, coverage of the behavioural literature." (Financial Times, Saturday 15th December 2007)
"...one of the few 'must read' books on the topic of investing." (The Herald - Glasgow, Saturday 2nd February 2008)
"…a fantastic insight into how markets operate… [and] one of the few "must read" on the topic of investing." (The Herald, Sat 2nd February 2008)
Table of ContentsPreface xvii
Acknowledgments xxi
Section I: Common Mistakes and Basic Biases 1
1 Emotion, Neuroscience and Investing: Investors as Dopamine Addicts 3
Spock or McCoy? 5
The Primary of Emotion 5
Emotions: Body or Brain? 6
Emotion: Good, Bad of Both? 7
Self-Control is Like a Muscle 11
Hard-Wired for the Short Term 13
Hard-Wired to Herd 14
Plasticity as Salvation 15
2 Part Man, Part Monkey 17
The Biases We Face 19
Bias #1: I Know Better, Because I Know More 19
The Illusion of Knowledge: More Information Isn’t Better Information 20
Professionals Worse than Chance! 21
The Illusion of Control 22
Bias #2: Big ≠ Important 23
Bias #3: Show Me What I Want to See 23
Bias #4: Heads was Skill, Tails was Bad Luck 24
Bias #5: I Knew it all Along 25
Bias #6: The Irrelevant has Value as Input 25
Bias #7: I Can Make a Judgement Based on What it Looks Like 27
Bias #8: That’s Not the Way I Remember it 28
Bias #9: If you Tell Me it Is So, It Must be True 29
Bias #10: A Loss Isn’t a Loss Until I Take It 30
Conclusions 35
3 Take a Walk on the Wild Side 37
Impact Bias 39
Empathy Gaps 40
Combating the Biases 44
4 Brain Damage, Addicts and Pigeons 47
5 What Do Secretaries’ Dustbins and the Da Vinci Code have in Common? 55
6 The Limits to Learning 63
Self-Attribution Bias: Heads is Skill, Tails is Bad Luck 67
Hindsight Bias: I Knew it All Along 69
Skinner’s Pigeons 71
Illusion of Control 72
Feedback Distortion 73
Conclusions 76
Section II: The Professionals and the Biases 77
7 Behaving Badly 79
The Test 81
The Results 82
Overoptimism 82
Confirmatory Bias 83
Representativeness 84
The Cognitive Reflection Task (CRT) 85
Anchoring 87
Framing 87
Loss Aversion 89
Keynes’s beauty contest 90
Monty Hall Problem 92
Conclusions 94
Section III: The Seven Sins of Fund Management 95
8 A Behavioural Critique 97
Sin city 99
Sin 1: Forecasting (Pride) 99
Sin 2: The Illusion of Knowledge (Gluttony) 100
Sin 3: Meeting Companies (Lust) 100
Sin 4: Thinking You Can Outsmart Everyone Else (Envy) 100
Sin 5: Short Time Horizons and Overtrading (Avarice) 101
Sin 6: Believing Everything You Read (Sloth) 101
Sin 7: Group-Based Decisions (Wrath) 101
Alternative Approaches and Future Directions 102
Sin 1: Forecasting (Pride) 103
9 The Folly of Forecasting: Ignore all Economists, Strategists, & Analysts 105
Overconfidence as a Driver of Poor Forecasting 109
Overconfidence and Experts 110
Why Forecast When the Evidence Shows You Can’t? 114
Unskilled and Unaware 115
Ego Defence Mechanism 115
Why Use Forecasts? 119
Debasing 120
10 What Value Analysts? 123
Sin 2: Illusion of Knowledge (Gluttony) 131
11 The Illusion of Knowledge or Is More Information Better Information? 133
Sin 3: Meeting Companies (Lust) 141
12 Why Waste Your Time Listening to Company Management? 143
Managers are Just as Biased as the Rest of Us 145
Confirmatory Bias and Biased Assimilation 148
Obedience to Authority 151
Truth or Lie? 153
Conclusions 157
Sin 4: Thinking You Can Outsmart Everyone Else (Envy) 159
13 Who’s a Pretty Boy Then? Or Beauty Contests, Rationality and Greater Fools 161
Background 163
The Game 163
The Solution 164
The Results 165
A Simple Model of Our Contest 168
Comparison with Other Experiments 170
Learning 173
Conclusions 174
Sin 5: Short Time Horizons and Overtrading (Avarice) 177
14 ADHD, Time Horizons and Underperformance 179
Sin 6: Believing Everything You Read (Sloth) 187
15 The Story is The Thing (or The Allure of Growth) 189
16 Scepticism is Rare or (Descartes vs Spinoza) 197
Cartesian Systems 199
Spinozan Systems 199
Libraries 200
A Testing Structure 200
The Empirical Evidence 200
Strategies to Counteract Naïve Belief 203
Sin 7: Group Decisions (Wrath) 207
17 Are Two Heads Better Than One? 209
Beating the Biases 215
Section IV: Investment Process as Behavioural Defence 217
18 The Tao of Investing 219
Part A: the Behavioral Investor 223
19 Come Out of the Closet (or, Show Me the Alpha) 225
The Alpha 228
The Evolution of the Mutual Fund Industry 229
Characteristics of the Funds 231
The Average and Aggregate Active Share 231
Persistence and Performance 231
Conclusions 233
20 Strange Brew 235
The Long Run 237
Death of Indexing 238
Getting the Long Run Right 238
The Short Run 239
Tactical Asset Allocation 239
Equity Managers 240
Break the Long-Only Constraint 242
Add Breadth 244
Not Just an Excuse for Hedge Funds 245
Truly Alternative Investments 245
Conclusions 246
21 Contrarian or Conformist? 247
22 Painting by Numbers: An Ode to Quant 259
Neurosis or Psychosis? 261
Brain Damage Detection 262
University Admissions 263
Criminal Recidivism 263
Bordeaux Wine 263
Purchasing Managers 264
Meta-Analysis 264
The Good News 267
So Why Not Quant? 268
23 The Perfect Value Investor 271
Trait I: High Concentration In Portfolios 273
Trait II: They Don’t Need to Know Everything, and Don’t Get Caught in the Noise 276
Trait III: A Willingness to Hold Cash 276
Trait IV: Long Time Horizons 277
Trait V: An Acceptance of Bad Years 278
Trait VI: Prepared to Close Funds 278
24 A Blast from the Past 279
The Unheeded Words of Keynes and Graham 281
On the Separation of Speculation and Investment 281
On the Nature of Excess Volatility 282
On the Folly of Forecasting 283
On the Role of Governance and Agency Problems 284
On the Importance (and Pain) of Being a Contrarian 285
On the Flaws of Professional Investors 286
On the Limits to Arbitrage 286
On the Importance of the Long Time Horizon 287
On the Difficulty of Defining Value 288
On the Need to Understand Price Relative to Value 288
On Why Behavioural Errors don’t Cancel Out 289
On Diversification 289
On the Current Juncture 289
On the Margin of Safety 290
On Beta 291
On the Dangers of Overcomplicating 291
On the Use of History 291
25 Why Not Value? The Behavioural Stumbling Blocks 293
Knowledge ≠ Behaviour 295
Loss Aversion 296
Delayed Gratification and Hard-Wiring for the Short Term 297
Social Pain and the Herding Habit 300
Poor Stories 301
Overconfidence 301
Fun 303
No, Honestly I Will Be Good 303
Part B: the Empirical Evidence: Value in All Its Forms 305
26 Bargain Hunter (or It Offers Me Protection) 307
Written with Rui Antunes
The Methodology 308
Does Value Work? 309
The Anatomy of Value 310
The Siren of Growth 311
Growth Doesn’t Mean Ignoring Valuation 311
The Disappointing Reality of Growth 313
Analyst Accuracy? 314
Value versus Growth 316
Key points 317
Regional Tables 318
Global 318
USA 320
Europe 323
Japan 325
27 Better Value (or The Dean Was Right!) 329
Written with Rui Antunes
28 The Little Note that Beats the Market 337
Written with Sebastian Lancetti
The Methodology and the Data 339
The Results 340
The Little Book Works 340
Value Works 341
EBIT/EV Better than Simple PE 341
Quality Matters for Value 341
Career Defence as an Investment Strategy 342
What About the Long/Short View? 343
The Future for the Little Book 344
Tables and Figures 345
Regional Results 345
29 Improving Returns Using Inside Information 355
Patience is a Virtue 357
Using Inside Information 357
A Hedge Perspective 359
Risk or Mispricing? 359
Evidence for Behavioural Errors 360
Evidence Against the Risk View 361
European Evidence 363
Conclusions 365
30 Just a Little Patience: Part I 367
31 Just a Little Patience: Part II 375
Written with Sebastian Lancetti
Value Perspective 377
Growth Perspective 380
Growth and Momentum 381
Value for Growth Investors 382
Value and Momentum 383
Implications 383
32 Sectors, Value and Momentum 387
Value 389
Momentum 389
Sectors: Value or Growth 390
Stocks or Sectors 391
33 Sector-Relative Factors Works Best 395
Written with Andrew Lapthorne
Methodology 398
The Results 398
Conclusion 403
34 Cheap Countries Outperform 405
Strategy by Strategy Information 409
Part C: Risk, but Not as We Know It 423
35 CAPM is CRAP (or, The Dead Parrot Lives!) 425
A Brief History of Time 427
CAPM in Practice 427
Why Does CAPM Fail? 431
CAPM Today and Implications 432
36 Risk Managers or Risk Maniacs? 437
37 Risk: Finance’s Favourite Four-Letter Word 445
The Psychology of Risk 447
Risk in Performance Measurement 447
Risk from an Investment Perspective 448
Section V: Bubbles and Behaviour 453
38 The Anatomy of a Bubble 455
Displacement 457
Credit Creation 457
Euphoria 459
Critical Stage/Financial Distress 459
Revulsion 463
39 De-bubbling: Alpha Generation 469
Bubbles in the Laboratory 471
Bubbles in the Field 472
Displacement: The Birth of a Boom 473
Credit Creation: Nurturing the Boom 473
Euphoria 476
Critical Stage/Financial Distress 477
Revulsion 483
Applications 487
Asset Allocation 487
Alpha Generation 488
Balance Sheets 489
Earnings Quality 489
Capital Expenditure 490
Long-Only Funds 491
Summary 491
40 Running with the Devil: A Cynical Bubble 493
The Main Types of Bubble 496
Rational/Near Rational Bubbles 496
Intrinsic Bubbles 498
Fads 499
Informational Bubbles 499
Psychology of Bubbles 500
Composite Bubbles and the De-Bubbling Process 500
Experimental Evidence: Bubble Echoes 503
Market Dynamics and the Investment Dangers of Near Rational Bubbles 503
Conclusions 505
41 Bubble Echoes: The Empirical Evidence 507
Conclusions 516
Section VI: Investment Myth Busters 519
42 Belief Bias and the Zen Investing 521
Belief Bias and the X-System 524
Confidence Isn’t a Proxy for Accuracy 528
Belief Bias and the Zen of Investing 528
43 Dividends Do Matter 529
Conclusions 540
44 Dividends, Repurchases, Earnings and the Coming Slowdown 541
45 Return of the Robber Barons 549
46 The Purgatory of Low Returns 563
47 How Important is the Cycle? 573
48 Have We Really Learnt So Little? 581
49 Some Random Musings on Alternative Assets 587
Hedge Funds 589
Commodities 590
Which Index? 590
Composition of Commodity Futures Returns 591
The Times They are A-Changin’ 591
Conclusions 595
Section VII: Corporate Governance and Ethics 597
50 Abu Ghraib: Lesson from Behavioural Finance and for Corporate Governance 599
Fundamental Attribution Error 601
Zimbardo’s Prison Experiment 602
Milgram: The Man that Shocked the World 604
Conditions that Turn Good People Bad 608
Conclusions 609
51 Doing the Right Thing or the Psychology of Ethics 611
The Ethical Blindspot 613
The Origins of Moral Judgements 614
Examples of Bounded Ethicality and Unconscious Biases 617
Implicit Attitudes (Unconscious Prejudices) 617
In-Group Bias (Bias that Favours Your Own Group) 619
Overclaiming Credit (Bias that Favours You) 620
Conflicts of Interest (Bias that Favours Those Who Can Pay You) 621
Mechanisms Driving Poor Ethical Behaviour 627
Language Euphemisms 628
Slippery Slope 628
Errors in Perceptual Causation 628
Constraints Induced by Representations of the Self 629
Combating Unethical Behaviour 629
52 Unintended Consequences and Choking under Pressure: The Psychology of Incentives 631
Evidence from the Laboratory 635
Evidence from the Field 638
Child Care Centres 638
Blood Donations 638
Football Penalty Kicks 639
Basketball Players 640
Back to the Laboratory 640
Who is Likely to Crack Under Pressure? 641
Conclusions 643
Section VIII: Happiness 645
53 If It Makes You Happy 647
Top 10 653
54 Materialism and the Pursuit of Happiness 655
Aspiration Index 657
Materialism and Happiness: The Evidence 658
Problems of Materialism 660
What to Do? 660
Why Experiences Over Possessions? 663
Conclusions 665
References 667
Index 677
