"The first principle is that you must not fool yourself - and you are the easiest person to fool." — Richard Feynman



When I read James Montier I get the idea that he would have been quite comfortable being born in a different era. For philosophy buffs, I view him as the Immanuel Kant of modern finance, a great thinker whose work has helped to bridge the gap between the rational vs. the empirical schools of thought in finance.



Montier is a polymath; in many regards he is similar to Ben Graham, although his interests lie more along the lines of traditional philosophy, economics and human behavior rather than the classical arts. Montier has become one of the world's foremost authorities on the role the human brain plays in investing. More specifically, Montier's work has been extremely helpful in cataloging thought processes and human behavioral phenomena which tend to damage investment returns. While Graham conceptualized the notion of "Mr. Market,” Montier has been successful in breaking down and analyzing the individual components which explain the behavior of "Mr. Market."



The value of Montier's work for the average individual is tantamount to an investing catharsis; sort of a Bodhi (spiritual enlightenment) which allows investors to understand the psychological processes which interfere with the long-term capital appreciation of their stock portfolios. If change can occur as a result of enlightenment, then reading the work of Montier is every bit as important as being able to accurately analyze the intrinsic value of a business.



Behavioral Characteristics Which Hinder Investors



Montier expounded upon some of his ideas in regard to human psychology, evolution and investing bias in a 2006 article where he elaborated on some of the facets of human behavior which hinder the results of investors.



Leaving the trees could have been our first mistake. Our minds are suited to solving problems related to our survival rather than being optimized for investment decisions.



Every fund manager who comes to one of my presentations takes a 20-question test that convinces them they suffer exactly the same biases as everyone else. People respond to that in one of two ways: The first is to say, "Now I understand it, I'm smarter than everyone else, so I can outthink everyone else." No, you can't! You've just failed behavioral economics 101, which explains that we are all overconfident in our abilities. The other response is, "Okay, I understand my biases. Now help me develop processes to spot where they are most likely to occur, and minimize the scale of these biases."



For example, I tell fund managers to examine the sorts of questions they ask when they meet company CEOs and directors. Most people ask questions that will generate the answers they want to hear. Philosopher Karl Popper wrote that after you set up a hypothesis, you should test it to destruction. You should look for all the evidence that goes against your view. But that doesn't happen in the City or on Wall Street. If someone takes a view on a stock or a market, he wants to hear all the evidence that supports that view. Most people are not inclined to sit down with people who disagree with them.



Why does meeting companies hold such an important place in the investment process of many fund managers? Because we need to fill our time with something that makes us look busy.



There are several psychological reasons why meeting company management could well be a complete waste of time. Much of the information provided by companies is noise. We already suffer from informational deluge, so why add to the burden? Likewise, corporate managers are just as likely as the rest of us to suffer from cognitive illusions. They display just as much over optimism and overconfidence as anyone else.



Another hurdle is our tendency to obey figures of authority. Company managers are often seen as being at the pinnacle of their profession; hence it's easy to imagine situations where analysts and fund managers find themselves overawed. Beyond that, we are simply lousy at telling deception from the truth. We perform roughly in line with pure chance, despite the fact that we all think we are excellent at spotting deception.



Our minds are not supercomputers and not even good filing cabinets. They bear more resemblance to Post-it Notes that have been thrown into a bin and covered in coffee. The ease with which we can recall information is likely to be influenced by the impact that information made when it went in.



We have lived in an industrial society for 300 years. Is that enough time for our brains to have adjusted from the way they were designed for surviving the African savanna? Probably not. Just because we have a brain does not mean we understand all that it does. To make better decisions, we need to think more about thinking.



Nine Behavioral Stumbling Blocks to Value Investing



Montier identified nine stumbling blocks to value investing in Chapter 14 of is book, "Value Investing: Tools and Techniques for Intelligent Investors.” I included some personal insight and commentary after each point.



1) Knowledge Does Not Equal Behavior



What a person knows does not necessarily translate into behavior change. Montier uses the example of AIDS and condom use; the fact that virtually everyone knows that the use of a condom protects them against the transmission of AIDS frequently does not result in the use of a condom.



I have noted the same phenomenon in the investing patterns of some of my friends. Specifically, in regard to the practice of momentum investing; virtually all of their winners have resulted from buying stocks which were well off their 52-week highs with favorable price valuations. On the other hand, virtually all their losers were a result of chasing momentum stocks breaking out to 52-week highs. Although they vow to change their behavior in the future and become more patient, they invariably revert back to the momentum strategy while continuing to show negative performance by following the same strategy.



2) Loss Aversion



Studies have shown that the average person dislikes losses at least twice as much as they enjoy gains. Overreaction to losses or the perception that losses are imminent is a huge stumbling block to value investors.



Loss aversion encourages investors to sell their holdings in the name of safety exactly at the time they should be buying. Case in point was the six month period from the late fall of 2008 the early spring of 2009. During that period, the prices of equities represented the most compelling valuations that they had seen for decades. However, the average investor had become extremely risk averse and the prospects of experiencing additional paper losses simply overwhelmed them. Instead of capitalizing on the favorable risk/reward scenario by purchasing stocks, most investors opted for holding a much larger percentage of cash than they had at any point in the last several decades.



3) Delayed Gratification and Hard-Wiring for The Short Term



Unfortunately it appears that human brains are chemically induced to react in the short term. The impulsive part of the brain (X-system) is laced with dopamine receptors which trigger pleasant feelings when an individual eats food or ingests cocaine for that matter. It appears that the prospect of quick gains triggers the release of dopamine which affects the X-system, thus encouraging an individual to act before the slower and more logical system of the brain (C-system) is able to override the impulse.



I vividly recall my C-system being overwhelmed by my X-system one day when I visited the gorilla display at the local zoo. I was among a crowd of people viewing a large male gorilla who was apparently unhappy about being confined inside on a beautiful spring day. Suddenly the gorilla charged the glass and banged both of his hands stoutly upon the enclosure. My impulsive retreat resembled the actions of George Costanza in the famous Seinfeld episode when he knocked women and children aside in response to fire panic in a crowded apartment. Of course no real danger was present. However, that fact had nothing to do with the chemical trigger that was sent to the X-system of my brain. The gorilla seemed to be particularly amused by my cowardice.



The above discussion would seem to indicate that patience, which is paramount in value investing, is not supported by human biology and brain chemistry. That conclusion is certainly supported by empirical evidence.



4) Social Pain and the Herding Habit



Warren Buffett once opined, "A pack of lemmings looks like a group of rugged individualists compared with Wall Street when it gets a concept in its teeth." It appears that the human herding instinct is a direct result of biological influences on the brain.



Montier cites research which indicates that social exclusion generates activity in the insular cortex area of the brain. Not coincidentally these areas of the brain are also activated by physical pain. In other words, social pain is not much different than physical pain when it comes to brain chemistry.



The obvious conclusion is that most people are simply not emotionally equipped to be contrarian in nature. One of the key tenets of value investing is having the emotional moxie to go against the grain. All great value investors are contrarians by nature as exemplified in Buffett's famous quote: "Be fearful when others are greedy. Be greedy when others are fearful." It would seem that the emotional pain caused to the average investor by following that creed is simply more than most investors can endure.



6) Poor Stories



Most stocks which are on sale have dismal stories attached to their current outlook. On the other hand, exactly the opposite is true with overpriced stocks. If you want to hear about great stories and overpriced stocks, tune to Cramer on any weekday evening. Cramer preaches to the choir and that choir has no interest in hearing about any stock that does not contain a seductive story; price and valuation are generally secondary considerations.



I often think that the updated version of "The Intelligent Investor" should contain a caricature of Jim Cramer as "Mr. Market." Cramer's persona seems to fit Graham's depiction of the raving, bipolar Mr. Market almost flawlessly.



7) Overconfidence



Overconfidence is a trait so universally associated with a brief period of success that it almost has to be a biological response in humans. Famous turf writer Andrew Beyer dubbed the phenomena as "The Messiah Complex" and it afflicts nearly every investor following periods of temporary success that includes the author of this article.



I frequently look at Whitney Tilson's list which begins with the admonition: Be Humble. That advice has been pretty easy to follow in the last few weeks as the market has dissipated.



8) Fun



It is much more stimulating to trade or to gamble than it is to engage in value investing. In fact it may be argued that it is more fun to do almost anything besides exercising the strict principles of value investing. Sitting passively is almost painfully boring during periods of market doldrums. Additionally, it is a rare individual who does not feel the intense urge to intervene and force the action, when their portfolios are diminishing in value or simply not appreciating as quickly as the portfolio of their neighbor. After all, who among us is not smarter than the fellow who resides next door?



9) No, Honestly, I Will Be Good



Famous last words similar to the phrase, "This time I learned my lesson.” Good intentions frequently do not correspond with a change in behavior once the immediate pain of the error subsides. I learned that lesson long ago in college when frequently I drank too many beers, although I vowed it would never happen again.



Conclusion



Humans are more biologically driven than most people believe. Understanding psychological and biological responses which hamper one's decision-making process is not only therapeutic but also important in maximizing long-term gains.



Virtually every investor is subject to the urges that Graham first described in his depiction of the bipolar Mr. Market. By specifically listing and recognizing the damaging characteristics which compile the portrait of Mr. Market, an investor is much less apt to succumb to his/her natural urges.



Investors who recognize their damaging tendencies can plan ahead to avoid overreacting to emotional stimuli. Templeton used to place limit orders well below the current price of the stock so he would not have to make a tough decision when the market was in utter retreat. It seems like that might be excellent advice considering the current market conditions.

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