7 Investing sins......

Since these common errors are self-imposed handicaps, identifying them
would result in a superior investment process.

Years ago, even before the financial crisis was spotted on the
horizon, James Montier of Dresdner Kleinwort Wasserstein came out with
a white paper titled “Seven Sins of Fund Management”. This holds true
even today and we reproduce them here as the common mistakes your
investors (or asset managers) make. If you find your investors
committing one of these “sins”, it’s time to reform their ways.

Sin 1: Forecast

Forecasting is an integral part of our lives, investment or not. Even
the weather cannot escape it. But a heavy dependence on it is sheer
folly because evidence indicates that your investors are bad at
forecasting. The core root of this inability seems to lie in the fact
that we all seem to be over-optimistic and over-confident. The answer
probably lies in a trait known asanchoring which means that in the
face of uncertainty, we will cling to any irrelevant number as
support.

Sin 2: The illusion of knowledge
The desire for more information stems from the efficient market
theory: if markets are efficient, then the only way they can be beaten
is by knowing something that no one else does. Your investors believe
that they need to know more than everyone else in order to outperform.

But 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.

Sin 3: Company interactions
Why do company meetings hold such an important place in the investment
process of many fund managers? The whitepaper gives at least five
psychological hurdles that must be overcome if meeting companies is to
add value to an investment process.

1.More information isn’t better information, so why join the futile
quest for an informational edge that probably doesn’t exist?
2.The views of corporate managers are likely to be highly biased.
3.We all tend to suffer from confirmatory bias – the habit of looking
for information that agrees with us. So rather than ask lots of hard
questions that test our base case, we tend to ask leading questions
that generate the answers we want to hear.
4.We have an innate tendency to obey figures of authority. Since
company managers have generally reached the pinnacle of their
profession, it is easy to envisage situations where analysts and fund
managers find themselves effectively awed.
5.We are lousy at telling truth from deception. We like to think
otherwise but we generally perform in line with pure chance. So even
when you meet companies, you won’t be able to tell whether they are
telling the truth or not.

Sin 4: Think you can out-smart everyone else
Keynes likened professional investment to a newspaper beauty contest
in which the aim was to pick the face that the average respondent
would deem to be the prettiest. We played a version of this game with
our clients to try to illustrate how hard it was to be just one step
ahead of everyone else. The results illustrate just what a tall order
such a strategy actually is. Only three out of 1,000 managed to pick
the correct answer!

The most common behavioural traits of over-optimism and
over-confidence are what lead money managers to believe that they can
out-smart everyone else. Everyone thinks they can get in at the bottom
and out at the top. However, this seems to be remarkably hubristic.

Sin 5: Short time horizons and overtrading
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 and overtrade as a consequence. This has nothing to do with
investment; it is speculation, pure and simple. Over very short
periods, the return is just a function of price changes. It has
nothing to do with intrinsic value or discounted cash flow.

Sin 6: Believing everything you read
We appear to be hard-wired to accept stories at face value. 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 fact, evidence suggests that in order to understand something we
have to believe it first. Then, if we are lucky, we might engage in an
evaluative process. Even the most ridiculous of excuses/stories is
enough to get results.  We need to be skeptical of the stories we are
presented with. Your investors would be better served by looking at
the facts, rather than getting sucked into a great (but often hollow)
tale.

Sin 7: Group-based decisions
Many of the decisions taken by your investors are the result of group
interaction.

The generally held belief is that groups are better at making
decisions than individuals. The dream model of a group is that it
meets, exchanges ideas and reaches sensible conclusions. The idea
seems to be that group members will offset each other’s biases.

Unfortunately, social psychologists have spent most of the last 30
years showing that groups’ decisions are amongst the worst decisions
ever made. Far from offsetting each other’s 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. 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.