Table of Contents
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To Connor
The best nephew a proud uncle could hope for
Preface
This book represents the first six years of an ongoing research project. The aim of this project was to truly understand the psychology of finance and investing and explore its implications for practitioners. There can be little doubt that behavioural finance has never been more popular among professional investors. Certainly, if my diary is any guideline, the subject is still in much demand. The chart below shows the number of times in a rolling 12-month period the words behavioural (or behavioral) finance appear in the press.
I reached the conclusion that I was a natural pessimist while looking at this chart, as the first thing that entered my mind was - its a bubble. An optimist would presumably conclude that it was a growth industry! I certainly hope the latter interpretation holds true.
My first book on the subject (Behavioural Finance, Wiley, 2002) was really the result of a series of lectures I had given to students. This book draws together research written for a professional audience whose time for reading research is highly limited. For this reason each chapter is written to stand alone to allow the reader to dip in and out at will. Each chapter also aims to deal with a practical issue of relevance to the professional investor. However, despite the independent nature of the chapters, I have chosen to group them together into themes, representing the seven major thrusts of my ongoing research project.
I Common Mistakes and Basic Biases
The title here gives the gist. In many ways one of the most powerful insights offered by the literature on judgement and decision making is that we are all prone to the potential pitfalls that psychologists have spent years documenting. Indeed, when I give a lecture to professional investors, those who probably get the most out of the talk are those who identify themselves as the perpetrators of behavioural mistakes. The chapters in this section aim to explore some of the most common biases, and suggest some simple ways in which we might be able to mitigate our susceptibility.
II The Professionals and the Biases
Among some there is a view that the individual investor is the source of all behavioural mispricing. However, I suspect this is far from true. Indeed there are now a number of papers (such as Jackson, Glushkov) that argue convincingly that the professionals may well be the noise traders. The aim of this section is to demonstrate that professional investors are just as likely to suffer behavioural biases as the rest of us. Indeed, in as much as they are experts in their field, they may well be even more overconfident and overoptimistic than lay people.
III The Seven Sins of Fund Management
The aim of this section was to examine a typical large institutional fund management organization and assess its vulnerabilities to psychological critique. The first step on the road to reform is to be able to identify the areas of weakness in the current structure. Issues such as an overreliance on forecasting, the illusion of trading, wasting time meeting company managements, and the dangers of overtrading are covered here.
IV An Investment Process as a Behaviour Defence
If the previous section represented a long list of donts, then this section is an attempt to provide a list of dos. It is concerned with investment philosophy/process. Since we cannot control the return on an investment (much as we would like to be able to do), then the best we can do is create a process that makes sense. Here we explore contrarian strategies and value investing as a framework for mitigating behavioural biases. As I am also an empirical sceptic, this section contains many empirical chapters based on demonstrating the principles discussed.
V Bubbles and Behaviour
Of all the areas of behavioural finance none captures the publics imagination like bubbles. This section explores a paradigm for analysing and assessing bubbles and their paths. It is a good demonstration of the constancy of human behaviour. Every bubble in history has been slightly different, but the underlying characteristics and processes are amazingly similar.
VI Investment Myth Busters
A popular TV show concerned two mad scientists who loved nothing more than to explode urban myths. This section represents my attempt to do something similar in finance. We have a bad habit of accepting theories as fact within finance, and of accepting statements as if they were truths. The chapters here try to expose some of the believable but incorrect beliefs that many investors seem to share.
VII Corporate Governance and Ethics
We often interpret other actions as evidence of their underlying nature. However, when people find themselves in a situation, we fail to understand the impact that has on their behaviour. So, rather than bad apples it is more often than not bad barrels, and the chapters here explore how social psychological insights can improve our understanding of corporate governance. We also explore one of economics most cherished beliefs - that incentives work - from a psychological perspective, and the results are intriguing, suggesting that optimal incentives are more difficult to design than many economists would have us believe.
VIII Happiness
This section deals with two of the most popular and most controversial notes I have written. They tackle the heresy of money not equalling happiness, which is clearly anathema to many who work in finance. These chapters explore the issue of what makes us happy, and what we can do to increase our level of happiness. These may seem like unusual topics for a researcher employed by an investment bank, but they were borne out of a belief that some of the most miserable people in the world seem to work in the field of finance.
Only you as reader will be able to judge how well I have achieved my aim of applying behavioural finance. Your comments and feedback would be most welcome and I can be contacted via my e-mail address: James.Montier@Googlemail.com
Acknowledgments
I am never sure who reads acknowledgements. Notwithstanding, there are several people to whom I owe a debt of gratitude. Firstly, my friend and colleague Albert Edwards. It was Albert who had the foresight to see that behavioural finance would be of interest to professional investors, and was prepared to support me in pushing the boundaries of what might be regarded as acceptable research. He also read most of the papers contained herein, and provided many useful suggestions to improve them, and challenge me.
Next, I must thank my co-authors on numerous of the empirical chapters in Section IV, Rui Antunes and Sebastian Lancetti of the Dresdner Kleinwort Quant team. Both gentlemen have more skill at dealing with data and quant models in their little finger than I have in my entire being. They both helped to take my ideas and turn them into raw hard numbers, to satisfy even the most demanding of empirical sceptics.