Monday, January 17, 2011

The Seven Sins of Fund Management

“This collection of notes aims to explore some of the more obvious behavioral weaknesses inherent in the ‘average’ investment process. Seven sins (common mistakes) were identified:

1. The first was placing forecasting at the very heart of the investment process. An enormous amount of evidence suggests that investors are generally hopeless at forecasting. So using forecasts as an integral part of the investment process is like tying one hand behind your back before you start.

2. Secondly, investors seem to be obsessed with information. Instead of focusing on a few important factors (such as valuations and earnings quality), many investors spend countless hours trying to become experts about almost everything. The evidence suggests that in general more information just makes us increasingly over-confident rather than better at making decisions.

3. Thirdly, the insistence of spending hours meeting company managements strikes us as bizarre from a psychological standpoint. We aren’t good at looking for information that will prove us to be wrong. So most of the time, these meetings are likely to be mutual love-ins. Our ability to spot deception is also very poor, so we won’t even spot who is lying.

4. Fourthly, many investors spend their time trying to ‘beat the gun’ as Keynes put it. Effectively, everyone thinks they can get in at the bottom and out at the top. However, this seems to be remarkably hubristic.

5. Fifthly, many investors seem to end up trying to perform on very short time horizons and overtrade as a consequence. The average holding period for a stock on the NYSE is 11 months [in 2005, nowadays is less, according to the same author]! This has nothing to do with investment; it is speculation, pure and simple.

6. Penultimately, we all appear to be hardwired to accept stories. However, stories can be very misleading. Investors would be better served by looking at the facts, rather than getting sucked into a great (but often hollow) tale.

7. And finally, many of the decisions taken by investors are the result of group interaction. Unfortunately groups are far more a behavioral panacea. In general, they amplify rather than alleviate the problems of decision making.

Each of these sins seems to be a largely self imposed handicap when it comes to trying to outperform. Identifying the psychological flaws in the ‘average’ investment process is an important first step in trying to design a superior version that might just be more robust to behavioral biases.”


James Montier – Seven Sins of Fund Management

No comments: