Behavioural investing seeks to bridge the gap between psychology and investing. All too many investors are unaware of the mental pitfalls that await them. Even once we are aware of our biases, we must recognise that knowledge does not equal behaviour. The solution lies is designing and adopting an investment process that is at least partially robust to behavioural decision-making errors. Behavioural Investing: A Practitioner's Guide to Applying Behavioural Finance explores the biases we face, the way in which they show up in the investment process, and urges readers to adopt an empirically based sceptical approach to investing. This book is unique in combining insights from the field of applied psychology with a through understanding of the investment problem. The content is practitioner focused throughout and will be essential reading for any investment professional looking to improve their investing behaviour to maximise returns. Key features include: * The only book to cover the applications of behavioural finance. * An executive summary for every chapter with key points highlighted at the chapter start. * Information on the key behavioural biases of professional investors, including The seven sins of fund management, Investment myth busting, and The Tao of investing. * Practical examples showing how using a psychologically inspired model can improve on standard, common practice valuation tools. Written by an internationally renowned expert in the field of behavioural finance. Behavioural investing seeks to bridge the gap between psychology and investing. All too many investors are unaware of the mental pitfalls that await them. Even once we are aware of our biases, we must recognise that knowledge does not equal behaviour. Preface. Acknowledgments. SECTION I: COMMON MISTAKES AND BASIC BIASES. 1 Emotion, Neuroscience and Investing: Investors as Dopamine Addicts.. Spock or McCoy? The Primary of Emotion. Emotions: Body or Brain? Emotion: Good, Bad of Both? Self Control is Like a Muscle. Hard Wired for the Short Term. Hard Wired to Herd. Plasticity as Salvation. 2 Part Man, Part Monkey. The Biases We Face. Bias #1: I Know Better, Because I Know More. The Illusion of Knowledge: More Information Isn t Better Information. Professionals Worse than Chance! The Illusion of Control. Bias #2: Big = Important. Bias #3: Show Me What I Want to See. Bias #4: Heads was Skill, Tails was Bad Luck. Bias #5: I Knew it all Along. Bias #6: The Irrelevant has Value as Input. Bias #7: I Can Make a Judgement Based on What it Looks Like. Bias #8: That s Not the Way I Remember it. Bias #9: If you Tell Me it Is So, It Must be True. Bias #10: A Loss Isn t a Loss Until I Take It. Conclusions. 3 Take aWalk on the Wild Side. Impact Bias. Empathy Gaps. Combating the Biases. 4 Brain Damage, Addicts and Pigeons. 5 What Do Secretaries Dustbins and the Da Vinci Code have in Common? 6 The Limits to Learning. Self Attribution Bias: Heads is Skill, Tails is Bad Luck. Hindsight Bias: I Knew it All Along. Skinner s Pigeons. Illusion of Control. Feedback Distortion. Conclusions. SECTION II: THE PROFESSIONALS AND THE BIASES. 7 Behaving Badly. The Test. The Results. Overoptimism. Confirmatory Bias. Representativeness. The Cognitive Reflection Task (CRT). Anchoring. Framing. Loss Aversion. Keynes s beauty contest. Monty Hall Problem. Conclusions. SECTION III: THE SEVEN SINS OF FUND MANAGEMENT. 8 A Behavioural Critique. Sin city. Sin 1: Forecasting (Pride). Sin 2: The Illusion of Knowledge (Gluttony). Sin 3: Meeting Companies (Lust). Sin 4: Thinking You Can Outsmart Everyone Else (Envy). Sin 5: Short Time Horizons and Overtrading (Avarice). Sin 6: Believing Everything You Read (Sloth). Sin 7: Group Based Decisions (Wrath). Alternative Approaches and Future Directions. Sin 1: Forecasting (Pride). 9 The Folly of Forecasting: Ignore all Economists, Strategists, & Analysts. Overconfidence as a Driver of Poor Forecasting. Overconfidence and Experts. Why Forecast When the Evidence Shows You Can t? Unskilled and Unaware. Ego Defence Mechanism. Why Use Forecasts? Debasing. 10 What Value Analysts? Sin 2: Illusion of Knowledge (Gluttony). 11 The Illusion of Knowledge or Is More Information Better Information? Sin 3: Meeting Companies (Lust). 12 WhyWaste Your Time Listening to Company Management? Managers are Just as Biased as the Rest of Us. Confirmatory Bias and Biased Assimilation. Obedience to Authority. Truth or Lie? Conclusions. Sin 4: Thinking You Can Outsmart Everyone Else (Envy). 13 Who s a Pretty Boy Then? Or Beauty Contests, Rationality and Greater Fools. Background. The Game. The Solution. The Results. A Simple Model of Our Contest. Comparison with Other Experiments. Learning. Conclusions. Sin 5: Short Time Horizons and Overtrading (Avarice). 14 ADHD, Time Horizons and Underperformance. Sin 6: Believing Everything You Read (Sloth). 15 The Story is The Thing (or The Allure of Growth). 16 Scepticism is Rare or (Descartes vs Spinoza). Cartesian Systems. Spinozan Systems. Libraries. A Testing Structure. The Empirical Evidence. Strategies to Counteract Naïve Belief. Sin 7: Group Decisions (Wrath). 17 Are Two Heads Better Than One? Beating the Biases. SECTION IV: INVESTMENT PROCESS AS BEHAVIOURAL DEFENCE. 18 The Tao of Investing. PART A: THE BEHAVIORAL INVESTOR. 19 Come Out of the Closet (or, Show Me the Alpha). The Alpha. The Evolution of the Mutual Fund Industry. Characteristics of the Funds. The Average and Aggregate Active Share. Persistence and Performance. Conclusions. 20 Strange Brew. The Long Run. Death of Indexing. Getting the Long Run Right. The Short Run. Tactical Asset Allocation. Equity Managers. Break the Long Only Constraint. Add Breadth. Not Just an Excuse for Hedge Funds. Truly Alternative Investments. Conclusions. 21 Contrarian or Conformist? 22 Painting by Numbers: An Ode to Quant. Neurosis or Psychosis? Brain Damage Detection. University Admissions. Criminal Recidivism. Bordeaux Wine. Purchasing Managers. Meta Analysis. The Good News. So Why Not Quant? 23 The Perfect Value Investor. Trait I: High Concentration In Portfolios. Trait II: They Don t Need to Know Everything, and Don t Get Caught in the Noise. Trait III: A Willingness to Hold Cash. Trait IV: Long Time Horizons. Trait V: An Acceptance of Bad Years. Trait VI: Prepared to Close Funds. 24 A Blast from the Past. The Unheeded Words of Keynes and Graham. On the Separation of Speculation and Investment. On the Nature of Excess Volatility. On the Folly of Forecasting. On the Role of Governance and Agency Problems. On the Importance (and Pain) of Being a Contrarian. On the Flaws of Professional Investors. On the Limits to Arbitrage. On the Importance of the Long Time Horizon. On the Difficulty of Defining Value. On the Need to Understand Price Relative to Value. On Why Behavioural Errors don t Cancel Out. On Diversification. On the Current Juncture. On the Margin of Safety. On Beta. On the Dangers of Overcomplicating. On the Use of History. 25 Why Not Value? The Behavioural Stumbling Blocks. Knowledge Behaviour. Loss Aversion. Delayed Gratification and Hard Wiring for the Short Term. Social Pain and the Herding Habit. Poor Stories. Overconfidence. Fun. No, Honestly I Will Be Good. PART B: THE EMPIRICAL EVIDENCE: VALUE IN ALL ITS FORMS. 26 Bargain Hunter (or It Offers Me Protection). The Methodology. Does Value Work? The Anatomy of Value. The Siren of Growth. Growth Doesn t Mean Ignoring Valuation. The Disappointing Reality of Growth. Analyst Accuracy? Value versus Growth. Key points. Regional Tables. Global. USA. Europe. Japan. 27 Better Value (or The Dean Was Right!). 28 The Little Note that Beats the Market. The Methodology and the Data. The Results. The Little Book Works. Value Works. EBIT/EV Better than Simple PE. Quality Matters for Value. Career Defence as an Investment Strategy. What About the Long/Short View? The Future for the Little Book. Tables and Figures. Regional Results. 29 Improving Returns Using Inside Information. Patience is a Virtue. Using Inside Information. A Hedge Perspective. Risk or Mispricing? Evidence for Behavioural Errors. Evidence Against the Risk View. European Evidence. Conclusions. 30 Just a Little Patience: Part I. 31 Just a Little Patience: Part II. Value Perspective. Growth Perspective. Growth and Momentum. Value for Growth Investors. Value and Momentum. Implications. 32 Sectors, Value and Momentum. Value. Momentum. Sectors: Value or Growth. Stocks or Sectors. 33 Sector Relative FactorsWorks Best. Methodology. The Results. Conclusion. 34 Cheap Countries Outperform. Strategy by Strategy Information. PART C: RISK, BUT NOT AS WE KNOW IT. 35 CAPM is CRAP (or, The Dead Parrot Lives!). A Brief History of Time. CAPM in Practice. Why Does CAPM Fail? CAPM Today and Implications. 36 Risk Managers or Risk Maniacs? 37 Risk: Finance s Favourite Four Letter Word. The Psychology of Risk. Risk in Performance Measurement. Risk from an Investment Perspective. SECTION V: BUBBLES AND BEHAVIOUR. 38 The Anatomy of a Bubble. Displacement. Credit Creation. Euphoria. Critical Stage/Financial Distress. Revulsion. 39 De bubbling: Alpha Generation. Bubbles in the Laboratory. Bubbles in the Field. Displacement: The Birth of a Boom. Credit Creation: Nurturing the Boom. Euphoria. Critical Stage/Financial Distress. Revulsion. Applications. Asset Allocation. Alpha Generation. Balance Sheets. Earnings Quality. Capital Expenditure. Long Only Funds. Summary. 40 Running with the Devil: A Cynical Bubble. The Main Types of Bubble. Rational/Near Rational Bubbles. Intrinsic Bubbles. Fads. Informational Bubbles. Psychology of Bubbles. Composite Bubbles and the De Bubbling Process. Experimental Evidence: Bubble Echoes. Market Dynamics and the Investment Dangers of Near Rational Bubbles. Conclusions. 41 Bubble Echoes: The Empirical Evidence. Conclusions. SECTION VI: INVESTMENT MYTH BUSTERS. 42 Belief Bias and the Zen Investing. Belief Bias and the X System. Confidence Isn t a Proxy for Accuracy. Belief Bias and the Zen of Investing. 43 Dividends Do Matter. Conclusions. 44 Dividends, Repurchases, Earnings and the Coming Slowdown. 45 Return of the Robber Barons. 46 The Purgatory of Low Returns. 47 How Important is the Cycle? 48 Have We Really Learnt So Little? (Part I Earnings; Levels not Trends). 49 Some Random Musings on Alternative Assets. Hedge Funds. Commodities. Which Index? Composition of Commodity Futures Returns. The Times They are A Changin . Conclusions SECTION VII: CORPORATE GOVERNANCE AND ETHICS. 50 Abu Ghraib: Lesson from Behavioural Finance and for Corporate Governance. Fundamental Attribution Error. Zimbardo s Prison Experiment. Milgram: The Man that Shocked the World. Conditions that Turn Good People Bad. Conclusions. 51 Doing the Right Thing or the Psychology of Ethics. The Ethical Blindspot. The Origins of Moral Judgements. Examples of Bounded Ethicality and Unconscious Biases. Implicit Attitudes (Unconscious Prejudices). In Group Bias (Bias that Favours Your Own Group). Overclaiming Credit (Bias that Favours You). Conflicts of Interest (Bias that Favours Those Who Can Pay You). Mechanisms Driving Poor Ethical Behaviour. Language Euphemisms. Slippery Slope. Errors in Perceptual Causation. Constraints Induced by Representations of the Self. Combating Unethical Behaviour. 52 Unintended Consequences and Choking under Pressure: The Psychology of Incentives. Evidence from the Laboratory. Evidence from the Field. Child Care Centres. Blood Donations. Football Penalty Kicks. Basketball Players. Back to the Laboratory . Who is Likely to Crack Under Pressure? Conclusions. SECTION VIII: HAPPINESS. 53 If It Makes You Happy. Top 10. 54 Materialism and the Pursuit of Happiness. Aspiration Index. Materialism and Happiness: The Evidence. Problems of Materialism. What to Do? Why Experiences Over Possessions? Conclusions. References. Index.