5 mistakes equity investors make

By Larissa Fernand |  23-09-14 | 
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About the Author
Larissa Fernand is Senior Editor at Morningstar.in. Follow her on Twitter @larissafernand

Almost a decade ago, James Montier penned Seven Sins of Fund Management, a behavioural critique. His report is packed with smart observations, backed up with data and charts. Although the presentation of his ideas is sometimes tongue-in-cheek, the learnings are invaluable.

From there we have taken five mistakes that he believes equity investors make.

1) Placing forecasting at the heart of the investment process 

Using forecasts as an integral part of the investment process is like tying one hand behind your back before you start. An enormous amount of evidence and anecdotal experience suggests that investors are generally hopeless at it. The core root of this inability seems to lie in the fact that we all seem to be over-optimistic and over-confident.

Effectively people are generally much too sure about their ability to predict. This tendency is particularly pronounced amongst experts. Several studies confirm professional investors to be particularly overconfident. For instance, one study found that 68% of analysts thought they were above average at forecasting earnings! I’ve found that 75% of fund managers think they are above average at their jobs.

Why do we persist in using forecasts in the investment process? The answer probably lies in a trait known as anchoring which means that in the face of uncertainty, we will cling to any irrelevant number as support.

The solution

Stop relying on pointless forecasts. There are investment strategies that don’t need forecasts as inputs such as value strategies based on trailing earnings, or momentum strategies based on past prices. Secondly, analyse rather than try to guess the unknowable.

2) Equating information with knowledge

We tend to equate information with knowledge. Sadly the two are often very different beasts. We also tend to labour under the misapprehension that more information is the same as better information. Experimental evidence suggests that often where information is concerned less is more!

Psychological literature suggests that we have cognitive limits to our capacity to handle information. Indeed we seem to make the same decision regardless of the amount of information we have at our disposal. Beyond pretty low amounts of information, anything we gather generally seems to increase our confidence rather than improve our accuracy. So more information isn’t better information, it is what you do with it, rather than how much you collect that matters.

Despite our obvious cognitive constraints, many investors persist in believing that in order to outperform they need to know more than everyone else. Hence they get caught up trying to know absolutely everything there is to know about a stock before investing. Numerous studies have shown that increasing information leads to increased overconfidence rather than increased accuracy.

The solution

Rather than obsessing with the bewildering informational fusion of news and noise, we should concentrate on a few key elements in stock selection, i.e. what are the five most important things we should know about any stock we are about to invest in?

3) Short-time horizons and overtrading

Many investors seem to end up trying to perform on very short time horizons and overtrade as a consequence. Because so many investors end up confusing noise with news, and trying to out-smart each other, they end up with ridiculously short time horizons. The average holding period for a stock on the New York Stock Exchange is 11 months! Over 11 months your return is just a function of price changes. It has nothing to do with intrinsic value or discounted cash flow. It is just people punting on stocks, speculating not investing. Recent evidence suggests that the average holding period of mutual fund investors has fallen from over 10 years in the 1950s to around a few years currently.

ADHD (Attention Deficit Hyperactivity Disorder) seems to plague financial markets at all levels. Performance is measured on increasingly short time horizons. Such myopia is often self-fulfilling, the more an investment is checked the more likely you are to find a loss.

The solution

We need to extend our time horizons. It also requires that investors try to stop ‘beating the gun’: instead of focusing on speculation, we need to refocus our industry on enterprise e (Keynes’ term for the activity of forecasting the prospective yield of assets over their whole life).

4) Believing everything you read

We all appear to be hardwired to accept stories at face value. However, stories can be very misleading. Investors would be better served by looking at the facts, rather than getting sucked into a great (but often hollow) tale.

We all love a story. Stock brokers spin stories which act like sirens drawing investors onto the rocks. More often than not these stories hold out the hope of growth, and investors find the allure of growth almost irresistible. The only snag is that all too often that growth fails to materialise.

In a rational world, we gather evidence, weight it and then decide. However, people rely on stories instead. We gather the evidence (in a biased fashion), construct a story to explain the evidence, and then match the story to a decision. This reliance on stories helps to drive investors into the growth trap.

Investors seem to frame their worlds in terms of stories rather than facts. It is exactly this trait that makes stories so dangerous. All too often investors are sucked into plausible sounding stories. Indeed, underlying some of the most noted bubbles in history are kernels of truth. For instance, the story that the internet would alter the way the world did business is probably true, but it doesn’t necessarily translate into profits for investors.

The solution

When you are really trying to assess the validity of an argument do your best to avoid distraction. Turn off your screens, put your phone on call forward, and try to cut yourself off from all the sources of noise. If you are likely to be distracted then either wait until later, when you can give the assessment the time and effort it requires.

5) Make decisions as a result of group interactions

Many of the decisions taken by investors are the result of group interaction.

Unfortunately, groups are far more a behavioural panacea. Contrary to the generally held belief that groups are better at making decisions than individuals, in general groups amplify rather than alleviate the problems of decision making. Far from offsetting each others biases, groups usually end up amplifying them! Groups tend to reduce the variance of opinions, and lead members to have more confidence in their decisions after group discussions (without improving accuracy).

They also tend to be very bad at uncovering hidden information. Indeed, members of groups frequently enjoy enhanced competency and credibility in the eyes of their peers if they provide information that is consistent with the group view. So using groups as the basis of asset allocation or stock selection seems to be yet another self imposed handicap on performance.

The solution

All too often people tend to believe that they know best on almost every subject. Request someone to play a devil’s advocate. Talk to someone with a strong contrarian view. Examine other alternatives.

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