It is a common perception that investing is all about having the right knowledge about the dynamics of the market, the sectors and ultimately the investible companies. However, knowledge is not the only thing that matters. Even the most knowledgeable investors may not be successful investors, if they are not able to control their emotions. Investing is not just about finding the right schemes, buying and selling them to make a profit. Finding the right scheme is a very important step, but in addition to this, what ensures sustained success in investing, is control over behaviour and emotions.

In his book on Behavioural Investing, author James Montier touches upon such non-financial aspects in the field of investing. He highlights some of the most destructive behavioural biases and common mental mistakes often made by investors leading to investment losses. Appropriately, the book is titled ‘The Little Book of Behavioural Investing: How not to be your own worst enemy?’ With the help of examples not only from the world of investing, but also from life in general, James Montier explains the reasons for the existence of these mental pitfalls, and the ways in which investors could protect their portfolios by overcoming these biases.

The Human Brain – X-system and C-system :

According to psychologists, the X-system of the human brain makes decisions based on emotions. The X-system is automatic and effortless. The judgements made by the X-system are generally based on aspects such as similarity, familiarity and proximity (in time). The C-system of the human brain processes information in a more logical way. It attempts to follow a deductive, logical approach to problem solving and decision making.

We would like to believe that we make more use of our C-system. However, the reality is that the X-system handles far more of our actions that we would be comfortable to admit. In fact, very often we end up trusting our initial emotional reaction, and only occasionally do we recruit the C-system to review the decision. This is because the X-system is a quick and dirty way of finding answers, whereas the C-system requires detailed logical thinking. Investors are no exception to this, as they too rely heavily on the X-system. We do not have control over our urges, which is reflected in our actions when we make hasty buy and sell investment decisions. Legendary investor Warren Buffett has said that investors need to control their X-system. He says “Success in investing does not correlate with IQ once you are above the level of 100. Once you have ordinary intelligence, what you need is the temperament to control your urges that get other people in to trouble of investing.”

This book discusses various behavioural biases, and ways in which we could overcome them. We will talk about a few biases in this blog, and the remaining will be covered in our next blog.

In the Heat of the Moment – Plan, prepare and pre-commit :

In tough situations, humans often use their X-system to make decisions. They suffer from what James Montier calls, the empathy gap. Empathy gap is when, in response to a situation, a person behaves differently when in a calm state of mind and differently when in the heat of the moment. Poor decisions are made in the heat of the moment and better decisions are made when in a calm state of mind. Hence, it is essential that investors prepare, plan and pre-commit to a strategy. On the backdrop of such preparation and pre-commitment, an investor’s view and action towards a scheme will not change in the heat of the moment (in case of frenzied selling or in the case of a mad rush to buy). One way to not be influenced by the heat of the moment is to have a wish-list of schemes and buy them only they reach the desired NAV, irrespective of the actions of other investors.

Why fear the Market?

It is not very easy to befriend the market, more so if you have suffered a loss. Fear of further loss causes people to ignore Equity schemes when they are available at attractive prices (NAVs). In such situations, people who use their X-system run out of self-control faster than those who use their C-system. They feel a state of temporary paralysis, wherein holding cash appears to be the best option. The solution to this is again pre-commitment. If you stick to your pre-committed strategy, and the fundamentals suggest you to buy, then you will buy only at an attractive price, and not take market driven decisions.

Let us not be over-optimistic, to the extent of being impractical :

Contrary to the above situation, when people see a positive movement in their investments, they tend to get over-optimistic. Over-optimism leads to illusion of control, wherein investors feel that they have a control over the outcome (which can never be the case in investing). Over-optimistic investors suffer from multi adviser or self-servicing biases. People having self-serving bias are prone to act in ways that are supportive of their own interests. Warren Buffett’s warning ‘Never ask a barber if you need a haircut’ best explains self-serving bias.

cont........ next blog