There is a huge body of academic work highlighting behavioural biases which consistently trip-up investors’ supposedly rational thinking. In this article we look at seven big sins of investing, with some examples and insights on how to avoid them.

A lot of the credit for these principles goes to Daniel Kahneman and Amos Tversky who collaborated in the 1960s to research apparent anomalies and contradictions in human behaviour.

Behavioural finance specialist James Montier compiled a list of the most common mistakes today’s investors make in a seminal piece of work when employed by Dresdner Kleinwort in 2005. This feature draws on Montier’s work to provide you with some ideas about how to improve your investment performance.

SIN ONE: PRIDE

Sixth century poet Lao Tzu wisely observed: ‘Those who have knowledge, don’t predict. Those who predict don’t have knowledge.’

Forecasting sits at the heart of many investment processes in the professional money management world, whether it involves forecasting ‘top down’ economic growth or ‘bottom-up’ company specific earnings.

There is nothing intrinsically wrong with attempting to forecast the future. That is, if the forecaster has a realistic view of his or her chances of being accurate. The problem is the odds are wildly stacked against forecasters. There is overwhelming evidence supporting the idea that humans are very poor forecasters.

This would not be such an issue if people recognised they were not very good. Unfortunately, this is not the case and overconfidence compounds the problem. Studies have shown that the worst forecasters tend to be those who are most overconfident.

These people are too sure about their ability to predict. They are described by statisticians as ‘not well calibrated’. Psychologists have devised simple tests for this. Imagine you were asked several difficult questions such as how old Martin Luther King was when he died, the diameter of the moon in miles and the weight of an empty Boeing 747 in pounds.  

Your task is to provide a low and high answer to each question which captures the actual answer. For example, you might guess 25 years to 50 years for the death of Martin Luther King (the answer is 39 years of age).

In one study of 1,000 participants who were asked 10 questions, fewer than 10 people gave nine correct answers and most respondents were in the four to seven range.

The main point here is that people who are well calibrated recognise what they do not know and adjust their guesses accordingly to make sure they capture the answer. The good news for retail investors is studies have shown that so-called experts in many fields, including professional money managers, tend to be more overconfident than lay people.

The bottom line is, there is a lot of evidence suggesting peoples’ opinions of their skills and abilities are at best moderately correlated with actual performance. A good way of dealing with these biases is to take analysts’ forecasts with a pinch of salt. If your chosen investment approach involves gazing into the future, it is wise to handicap your expectations to match your knowledge and degree of uncertainty. As investor Warren Buffet says: ‘I try to be roughly right rather than precisely wrong.’

SIN TWO: GLUTTONY – THE ILLUSION OF KNOWLEDGE

Information is more widely available today than ever before. There is a popular notion that having access to more information than anyone else is the key to outperformance, but sadly information is not the same thing as knowledge.

Studies have shown that less is more when it comes to information. Humans do not deal with information overload very well due to cognitive constraints. Another difficulty is related to the idea that once an investment decision has been made, new information merely increases confidence in the original decision rather than improving overall accuracy.

In other words, what you do with new information is far more important than how much of it you get. In the excellent book Super-Forecasting by Philip Tetlock and Dan Gardner, the authors find that the best forecasters deal with new information in a balanced, iterative way.

This is a learned skill honed by practice and requires the forecaster to be humble, cautious, and open-minded. These are the opposite traits of overconfident people. Another common bias in dealing with lots of information is investors tend to seek out confirmatory information supporting their investment thesis and ignore or downplay information undermining that thesis.

The psychological challenges of dealing with huge amounts of information can be mitigated to some extent by developing a mindset which focuses on what really matters and ignoring the noise. This involves thinking more like a long-term owner of a business rather than getting distracted by short-term share price volatility. It takes time and effort to figure out the key drivers of a business, but it can pay dividends in the long run.

NEIL WOODFORD’S STRATEGY SHIFT

After leaving Invesco in 2013 and setting up his own asset manager Woodford Investment Management, Woodford increasingly pursued a more growth-focused approach which involved picking smaller and in some cases unquoted businesses which he perceived as having significant growth potential.

In doing so he moved away from what had made him so successful at his previous employer Invesco Perpetual, namely buying mainly large cap stocks whose income potential had been undervalued by the market.

One of his big calls was buying big tobacco stocks in the early 1990s when others were fearful aggressive US authorities would drive them out of business. He subsequently benefited from significant capital gains and a steady flow of dividends.

By early 2019 nearly 20% of his eponymous Equity Income Fund was in companies which were not listed on a recognised stock market with ultimately disastrous consequences for the fund and its investors.

SIN THREE: GETTING SUCKED IN BY COMPANY MANAGEMENT TEAMS

Retail investors do not get the same level of access to senior management teams as fund managers, but this could be a good thing according to Montier.

Given the primary reason for visiting companies is to collect more information, this activity suffers from the same psychological challenges just discussed. It should also be remembered that companies are not allowed to discuss information not already in the public domain.

Overconfidence is not in short supply when it comes to company managements. For example, a Duke University chief financial officers study showed that corporate managers are always more optimistic about the outlook for their company than the economy at large.

Montier believes meetings between fund managers and companies can turn into ‘love-ins’ rather than constructive debates. Another challenge which comes into play with meeting managements is that people are poor at spotting deception. Company visits can be useful for getting a better understanding of how a business works, but if you are searching for an informational edge, you might be disappointed.

From a retail investor point of view, it is still worth engaging with opportunities to hear direct from management teams but it is always worth listening to their messaging with a healthy dose of scepticism.

SIN FOUR: ENVY

One study shows that 75% of investment managers believe they are better than average. This shouldn’t be surprising given the earlier discussion on overconfidence. The reality is few fund managers beat the market averages over the long term.

Even the very best managers suffer long periods of underperformance. Terry Smith’s Fundsmith Equity (B41YBW7) is a case in point, trailing its benchmark over the last three and five years. Longer term the fund has a superior track record, delivering a 15% annualised return since inception versus 11.8% for its benchmark.

The evidence suggests a period of underperformance is the price investors must pay for achieving long term success. This means investors might be better off focusing on achieving their long-term investment goals, within the parameters of their individual risk appetite, rather than worrying how other investors are performing.

In his original paper Montier introduces the idea of a beauty contest to represent how fund management works. The goal is not to pick the prettiest person but to choose who you think will receive the most votes.

It comes from economist John Maynard Keynes who said: ‘We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.’

SIN 5: PARTICIPATING IN SHORT-TERM TRADING

This brings the discussion to overtrading. Montier highlights that average holding periods at US mutual funds has fallen from over a decade in the 1950s to under five years today. Speculating on the short-term direction of the market or a particular stock is not a sensible strategy for most investors, bar a few professionals who can make it successful.

Timing the market is virtually impossible and is far less important than time in the market. Compounding works best when it is allowed time to do its magic.

MISSING JUST A FEW OF THE MARKET’S BEST DAYS CAN HAVE A BIG IMPACT

Research from BlackRock shows if you missed just the five best days on the S&P 500 between 31 December 2003 and 31 December 2023 you would have reduced the size of your final pot from an initial $10,000 investment from $63,637 to $40,193. 

Missing the best 10 days more than halved the hypothetical return and missing 25 days left you with just $14,093. This shows the merits of staying invested rather than seeking to trade in and out of the market during periods of volatility.

SIN SIX: BEING RULED BY THE ALLURE OF A GOOD STORY

Montier recalls a conversation with a colleague who said, ‘stockbrokers exist to sell dreams,’ to which Montier later added, ‘but they deliver nightmares’. Financial academics naively assume investors gather evidence, weigh up the risks, then make a rational investment decision, but that is not how things work in practice.

The reality, explains Montier, is that investors collect evidence, usually in a biased fashion, then construct a story to explain the evidence. This story, not the original evidence, is then used to reach an investment decision.

Humans are innately very good story tellers.  We have a need to make sense of the world and often see phantom connections. The same instincts which make us good story tellers can also get us into trouble when it comes to investing.

Stories may make sense in hindsight but on refection they are usually simplistic and fail to convey the complexity of underlying reality. Author and statistician Nassim Taleb calls this the ‘narrative fallacy’ in his book The Black Swan.

Daniel Kahneman explains it as follows: ‘Flawed stories of the past shape our views of the world and our expectations for the future. Narrative fallacies arise inevitably from our continuous attempt to make sense of the world.’

When you add confirmation bias to the equation, whereby we tend to look for supporting evidence and ignore contradictory information, it is easy to see how our expectations are often upended.

A defence against our weakness for a good story is to apply more scepticism and check the underlying facts, while reflecting on the logic being purported. Stories which sound too good to be true invariably are.

OCADO’S BIG PROMISE FAILS TO TRANSLATE INTO REALITY

Excitement about the potential for online groceries play Ocado (OCDO) to sell its so-called Ocado Smart Platform – an out-of-the-box solution for global supermarkets – took the stock to an all-time high market valuation of more than £21 billion in early 2021. The excitement was stoked by the pandemic and the almost overnight switch towards lots more people buying their weekly shop on the web. To put the peak valuation into perspective, the company’s total revenue was around £2.3 billion in the 12 months to 30 November 2020 and it chalked up a pre-tax loss of £44 million. While it has secured some agreements with big global retail brands, those losses have only increased, reaching £154 million in the six months to 2 June 2024. For all the excitement, Ocado is yet to build a tangible business generating profit and cash flow.

SIN 7: THINKING TWO HEADS ARE BETTER THAN ONE

Readers who participate in share clubs or collaborate with friends in making investment decisions are also subject to behavioural biases. You might expect a higher quality, more insightful decision from a group compared to individuals. Studies show this is not the case.

There is a tendency to conform rather than explore different views, and groups are at risk of suffering polarization and, in the extreme, groupthink.

These conclusions run counter to the idea of the wisdom of crowds, popularised by the book of the same name by James Surowiecki, so what is going on?

It transpires that under specific conditions, groups do outperform. For example, in one study comprising a group of 56 students who were asked to guess how many beans were in a jar containing 850 beans, they guessed 871, a better guess than almost all group members.

The ‘wisdom’ comes partly from the effect of outlying guesses cancelling each other out and the fact that each person’s guess is independently made without influence from other members of the group. When people get together, they tend to amplify rather than cancel out individual biases and extreme views. In reaching a consensus, variance is reduced.

The desire to find a consensus means the discussion tends to centre on information available to all group members which reduces the chances of uncovering anything new. Social pressure can also prohibit the sharing of information by people who do not want to look stupid in front of colleagues.

What can be done to defend against these biases? Secret ballots can remove some of the worst effects. Playing the role of ‘Devil’s Advocate’ is an effective way of discussing contrarian views and exploring non-consensus views. Finally, when group members are acknowledged to be experts, disparate viewpoints are easier to deal with and it is easier for unshared information to come to light.

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