Sunday, October 16, 2011

Book Review: The Little Book of Behavioral Investing, by James Montier

Given that James Montier’s The Little Book of Behavioral Investing recently topped the list of bestselling business books in Canada, according to the Globe & Mail newspaper (August 30th), now seemed like a particularly good time to provide a full review. In his latest book, Montier provides an introduction to behavioral economics. He identifies a list of common emotional pitfalls in regards to how we invest money and proposes some safeguards against most if not all of them.

Montier starts by introducing our brains’ two main decision-making systems. The X-System, having appeared first, is the more developed and corresponds to emotional decision-making. It uses mental shortcuts and is quicker to activate. The C-System has only developed in humans over the past few centuries. It corresponds to logical thinking and usually takes more time to activate. People who tend to rely more on their C-System tend to make far better investors. However there are serious limitations to it. It comes in limited supply (those who habitually use it more tend to get more usage of it) and even if you use it, you can still fall prey to a number of biases and other problems. These are:

1) Over-optimism bias
2) Self-serving bias
3) Overconfidence, especially demonstrated by experts
4) Confirmatory bias
5) Conservatism bias, in that we hang on to our views too long
6) Action bias

Montier takes a strong stance against many of today’s common investment practices. This starts with forecasting, which he compares to trying to be one step ahead of everyone. This is put in direct contrast to analysis of the facts on hand and knowing generally where you stand in a cycle or trend. He rails against our seeming addiction to collecting more information, despite this having no positive effect on the results from our decision-making (though it sure raises our confidence in our otherwise faulty decisions). A number of counters, some very practical, are put forward. For example, Montier advocates the use of pre-commitments, such as pre-entered buy and sell orders, in order to deal with our inability to predict how we will react in the future (that’s called an empathy gap). Another one is to keep an investment diary detailing the why of each decision at the time it was taken.

Montier generally takes the approach of introducing a behavioural problem and how it applies in the general population, giving an example or two, and then he presents how it manifests itself in the investor or the investment manager or both before prescribing a potential counter. Often the experiments have interesting results and implications. For instance, it is documented (and not the first or the last time I’ve seen this) that women are better investors than men. In another, he compares the confidence levels of predictions made by weathermen versus doctors and their actual accuracy.

Compared with his previous book Value Investing and other investing books, this one presents a different kind of usefulness. For one thing, it barely qualifies as an investing book as it deals strictly with psychology. There aren’t any investing nuggets so to speak or great lessons or much else of immediate, obvious practicality. What it does offer however is ways to take a hard look at ourselves and how we make decisions. Depending on your style, The Little Book of Behavioral Investing probably won’t be a book you will refer to particularly often but one you’ll go back to periodically over longer periods of time.