Review of "The Little Book of Behavioral Investing: How Not to be Your Own Worst Enemy" by James Montier

I have been an investor for over 40 years. This has taught me that my own psychology and behaviour are very important in determining my investment performance. In my investing career I have made good decisions and bad decisions; at times I have been brave and at other times I have allowed fear to paralyse me.

Accordingly when I saw this book, and particularly its small size, I had no hesitation in buying it.

Overview of the book

It is a small book in every way. The pages are relatively small with relatively large text and there are only 219 pages. Accordingly it is a very easy book to read.

Table of contents

The book is divided into a large number of short chapters and the best way to get an overview is simply a detailed list of the contents:

Foreword – Homo mistakus by John Mauldin
Introduction – This is a book about you: you are your own worst enemy

1. In the Heat of the Moment – Prepare, plan, and pre-commit to a strategy
2. Who’s Afraid of the Big Bad Market? – Re-investing when terrified
3. Always Look on the Bright Side of Life – “But, why should I own this investment?”
4. Why Does Anyone Listen to These Guys? – Stop listening to the experts!
5. The Folly of Forecasting – Prepare, don’t predict
6. Information Overload – Distinguishing the signal from the noise
7. Turn off That Bubblevision! – Volatility equals opportunity
8. See No Evil, Hear No Evil – It’s time to prove yourself wrong
9. In the Land of the Perma-Bear and the Perma-Bull – When the facts change, change your mind
10. The Siren Song of Stories – Focusing on the facts
11. This Time Is Different – Your biggest advantage over the pros
12. Right for the Wrong Reason, or Wrong for the Right Reason – Writing away your mistakes and biases
13. The Perils of ADHD Investing – Never underestimate the value of doing nothing
14. Inside the Mind of a Lemming – Becoming a contrarian investor
15. You Gotta Know When to Fold Them – When it’s time to sell an investment
16. Process, Process, Process – That one thing you can control

Conclusion: The Road to Hell Is Paved with Good Intentions – Why promising to be good just isn’t enough

It is not feasible to attempt to summarise the book but below I have chosen some extracts which give an impression of the content and style.

Foreword by John Mauldin

He explains that he is personally an expert on making bad choices and has also seen his children make bad choices when teenagers.

“I have interviewed hundreds of investors over the years, from small and starting out to having-arrived billionaires. I am always amazed by the mistakes they make and the inventive rationale they use for having made them.

…

It seems that our emotions and much of our decision-making process is hardwired into our brains, developed for survival on the African savannahs some 100,000 years ago. We adapted to movement, learning to make decisions quickly, because there was quite a difference, literally life and death, between dodging dangerous lions and chasing succulent antelope.

And while those survival instincts are quite useful in general, when translated into a modern world, and especially in modern investment world, they make us prone to all sorts of errors. Think of chasing momentum all too often in the hope that it will continue and a running from falling markets just as they start to turn. What works for survival in the African jungles is not as productive in the jungles of world finance.

…

We clearly learned to make good choices as well, and to learn from our mistakes and even the success and wisdom of others. As I mentioned earlier, I have formally interviewed hundreds of millionaires. I am even more fascinated by choices they made that were the good (and sometimes brilliant!) ones, and the processes they used to make them.”

Introduction – this is a book about you: you are your own worst enemy

The author acknowledges that he has never met you, but feels equipped to write about you because we are all human and all prone to making the same mistakes.

“Indeed, Ben Graham (the father of value investing) even went so far as to say ‘The investor’s chief problem – and even his worst enemy – is likely to be himself.’

Evidence of this harmful investor behaviour can be found in the annual Dalbar studies, which measure the actual returns achieved by investors rather than the returns from a passive index, such as the S&P 500. They also capture the degree to which investors attempt to time their entry and exit to the market (among other things). The results aren’t pretty. Over the last 20 years, the S&P 500 has generated just over 8% on average each year. Active managers have subtracted 1 or 2 percent from this, so you might be tempted to think that individual investors in equity funds would have earned a yearly 6 to 7 percent. However, equity fund investors have managed to reduce this to a paltry 1.9% per annum. This results from buying and selling at just about the worst possible point in time. Sure looks like Ben Graham was right – we really are our own worst enemies.”

Cognitive Reflection Test

The author mentions the Cognitive Reflection Test which is a test developed by Shane Frederick of Yale. It has three simple questions which are extremely effective at determining whether a person uses the emotional approach to decision-making or the logical way of processing information.

The author points out that it takes a deliberate effort to engage the logical thinking system whereas the emotional approach is the default approach of human beings.

The questions are as follows:

1. “A bat and ball together cost $1.10 in total. The bat costs a dollar more than the ball. How much does the ball cost?
2. If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?
3. In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?”

The author proceeds to give the answers and then reports on the performance of people in general.

“Don’t worry if you got one or all three of those questions wrong – you aren’t alone. In fact, after giving the test to nearly 3,500 people, Frederick found that only 17% of them managed to get all three questions right. 33% got none right! The best performing group were MIT students; 48% of them managed to get all three questions correct – but that is still less than half of some of the best students in the world. I’ve had 600 professional investors (fund managers, traders, and analysts) take these questions and only 40% managed to get all three questions correct, while 10% didn’t get any right.”

My own performance was to get all of them correct. There is no time limit and I simply considered each of them carefully as an exercise in mental arithmetic. When you do that the test is straightforward.

The danger comes from trying to rush to quick answers in each case without really thinking. Of course that behaviour is what the test is designed to identify.

The author gives details of another experiment which shows how your environmental circumstances can reduce your willpower, and considers that “Willpower alone is unlikely to be a sufficient defence against behavioural biases.”

He proceeds to quote Warren Buffett and Seth Klarman:

“As Warren Buffett said, ‘investing is simple but not easy.’ That is to say, it should be simple to understand how investing works effectively: You buy assets for less than their intrinsic value and then sell them when they are trading at or above their fair value. However, the gamut of behavioural bias that we display tends to prevent us from doing what we know we should. As Seth Klarman observes:

So if the entire country became securities analysts, memorised Benjamin Graham’s Intelligent Investor and regularly attended Warren Buffett’s annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads. People would still find it tempting to day-trade and perform technical analysis of stock charts. A country of security analysts would still overreact. In short, even the best-trained investors would make the same mistakes that investors have been making forever, and for the same immutable reason – that they cannot help it.”

Always Look on the Bright Side of Life – “But, why should I this investment?”

The author begins by reminding us that most others consider ourselves above average at driving cars, our jobs etc.

“Optimism seems ingrained in the human psyche. At the end of Monty Python’s Life of Brian, those hanging on crucifixes begin singing ‘Always look on the bright side of life.’ It would appear that the vast majority of people subscribe to this particular view of the world.”

Personally I regard optimism as a good thing. I have always been an inveterate optimist myself; so much so that a close colleague at Price Waterhouse once told me off about it! Apart from anything else, optimists tend to be happier than pessimists. However optimism in an investor can be financially dangerous.

The author explains how to beat over-optimism.

“What can we do to defend ourselves against over-optimism? We must learn to think critically and become more sceptical. We should get used to asking ‘Must I believe this?’ rather than the far more common ‘Can I believe this?’

…

Indeed, most of the best investors appear to ask themselves a very different default question from the rest of us. Many of these investors generally run concentrated portfolios, with the default question being ‘Why should I own this investment?’ Whereas for fund managers who are obsessed with tracking error and career risk, the default question changes to ‘Why shouldn’t I own this stock?’ This subtle distinction in default questions can have a dramatic impact upon performance.

Spencer Davidson of General American Investors recalls, ‘An early mentor of mine started out during the Depression and used to always say we were in the rejection business – that we’re paid to be cynical and that a big part of success in investing is knowing how to say no.’”

Information Overload – distinguishing the signal from the noise

The author points out how much information comes at investors and how easy it is to be distracted by looking at irrelevant information rather than thinking in a focused way. He cites an example from the medical profession of how an improved process can make a big difference.

“The power of simple checklists should not be under-estimated. One very recent study examined how the implementation of a simple 19-point surgical checklist might help save lives. The checklist covers things as simple as making sure someone had checked that this was the same patient everyone thought it was, that the nurses had reconfirmed the sterility of all the instruments, and that at the end of surgery, someone counted all the instruments and made sure the number was the same as at the start of the operation.

These might sound like the kind of things you hope would occur anyway. However, having the checklist forced people to go through the steps. The results of this checklist implementation were astounding. Prior to the introduction of the checklist the patient death rate was 1.8% and the complication post surgery rate was 11%. After the checklist was introduced the death rate dropped to 0.8% and the complication rate collapsed to 7%.

But, enough about doctors and their patients – what can investors learn from all of this? Simple: It is far better to focus on what really matters, rather than succumbing to the siren call of Wall Street’s many noise peddlers.

We would be far better off analysing the five things you really need to know about an investment, rather than trying to know absolutely everything about everything concerned with the investment.”

See No Evil, Hear No Evil – it’s time to prove yourself wrong

This chapter explains the concept of confirmation bias and how it leads us to make mistakes. After making a snap decision we seek out only information that supports the decision. I have previously used confirmation bias as the subject for one of my “Thought for the Week” radio talks.

Right for the Wrong Reason, Or Wrong for the Right Reason – writing away your mistakes and biases

The author points out how in sport we often attribute failure to bad luck and then tells us:

“The same thing happens when it comes to investing. It is all too easy for investors to dismiss poor results as examples of bad luck. On some occasions this may well be the case, that on others bad analysis may be the root cause.”

The author gives some practical advice to increase our self-discipline.

“So to combat the pervasive problem of self-attribution we really need to keep a written record of the decisions we take and the reasons behind those decisions – an investment diary, if you will. Keeping an investment diary may sound daft, but George Soros did exactly that. In his Alchemy of Finance he writes ‘I kept a diary in which I recorded the thoughts that went into my investment decisions on a real-time basis… The experiment was a roaring success in financial terms – life and never did better. It also produced a surprising result: I came out of the experiment with quite different expectations about the future.’

Having kept such a diary, we then need to map the outcomes of the decisions and the reasons behind those decisions into a quadrant diagram, like the one shown below.

…

Only by cross-referencing our decisions and the reasons for those decisions with the outcomes, can we hope to understand when we are lucky and when we have used genuine skill, and more importantly, where we are making persistent recurrent mistakes.”

	Good outcome	Bad outcome
Right reasoning	Skill (perhaps)	Bad luck
Wrong reasoning	Good luck	Mistake

Concluding comments

This book is short, very easy to read and entertaining. It will help you to think about yourself as an investor.

I have no hesitation in recommending it to everyone who ever makes any investments. It should make you into a better investor.

It has already had an impact on me. I have previously recorded some aspects of my valuation decisions, but have decided to become completely rigorous about writing down my reasoning for every purchase or sale decision so that I can review the decisions in the future with the benefit of hindsight.