In this new series, I will be exploring various concepts and ideas in James Montier’s excellent book, “The Little Book of Emotional Investing.” Although I’ve written before on many types of behavioural biases and fallacies, this book is a good addition to that literature as it covers additional aspects that can be combined to form a more complete picture.
The book does not only give a list of biases to be aware of, it also explains certain actions we can take to improve our investment process. Further, it highlights a few aspects of investing we may take for granted. Here are a few interesting ideas from the book.
Pre-commitment is a method to impose discipline on your thought process. It entails telling yourself what you would do under specific circumstances so that when such events play out, you do not end up freezing like a deer in the headlights. This helps in situations where emotions may run amuk, such as during times of stock market turmoil, as it allows investors to take actions that may limit losses and preserve capital.
Beware of brokerage reports
In yet another salvo fired at sell-side brokerages, James described how the self-serving bias is at play, here. There are three aspects to broker research that should make us very wary of trusting everything they say without question.
1. All news is good news. What better way to get people to buy than to package everything in a positive light? As I mentioned before, around 85% of all broker reports consist of “buy” recommendations, and when framed as good news, people tend to want to jump onto the bandwagon. And even when the news is bad, it can always get better!
2. Everything is always cheap. It seems that sometimes brokers need to invent new valuation methodologies to continue to convince people to buy. By stating that shares are always cheap, brokers can give the impression that everything is always a bargain, and we should be scooping up shares with open arms. Investors need to be wary of this over-selling and over-promotion of stocks with shaky or dubious business models. And of course, we also need to be able to differentiate between what’s actually cheap and what’s not.
3. Assertion trumps evidence. Brokers never let the facts get in the way of a good story. As long as they are able to spin a nice tale, some facts may be conveniently glossed over, or even ignored.
Illusion of knowledge
The illusion of knowledge is a pervasive phenomenon among investors. The greatest obstacle to discovery is not ignorance but the illusion that we think we know more than we actually do. The worst part is assuming the information and analysis you have is correct when it could actually be mistaken and flawed. This may lead investors to make poor decisions even though they may be confident in their logic. The solution to this is to use simple metrics for assessing an investment as opposed to complex valuation methodologies.
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