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7 Investing Sin’s

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 as anchoring 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 white paper 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.