The limiting factor for investors is not their IQ, but their temperament, rationality, and independent thinking. As Warren Buffet says, "You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. Rationality is essential. Even if you do have an IQ of 160, you should just give away 30 points to somebody else because you don't need a lot of brains to be in this business. What you do need is emotional stability. You have to be able to think independently."1
Investors who lack control over their temperament make foolish decisions during market extremes. They struggle to respond to unexpected events in a thoughtful way. Instead of approaching decisions in a calm and rational manner, they abandon their process and invest based on their gut. They can get lucky for a while, but eventually will fail. Even brilliant investors who get caught up in the euphoria of a market boom or the pessimism of a market crash will abandon what has worked so well for them. They can’t resist the overwhelming pressure to exert control and do something now, no matter how foolish in the long-run.
Some of this behavior may be heredity or genetic, but most is self-induced. Many investors obsess over every news story and try in vain to anticipate every new market development. Most of these are unpredictable and random, but that doesn’t stop investors with poor emotional control from trying to do the impossible. It leads to errors, overconfidence, and wasted energy.
Our temperament should not change based on market conditions. Ideally, we should have a stable foundation and a set of investment principles that guide us through any investment environment. There is uncertainty and doubt in most investment decisions, but that’s why we need to double down on our process and principles, and not panic and abandon what has worked for us.
It only takes one moment of weakness or irrationality to undo many good years of investing. For example, in the 2009 financial crisis, market panic overwhelmed previously successful investors. They made irrational decisions based on fear, conjecture and catastrophic thinking. Of course, investing during the crisis was not easy. Even the best investors would admit it was a gut-wrenching environment. But this was the difference – investors with poor emotional control abandoned their long-term investing principles and made decisions that devastated their investment portfolio.
For example, they gave up on regular rebalancing to their proper asset allocation. Instead of buying assets when they were exceptionally cheap, they bought into the idea that the financial world was ending and completely sold out of the market. By not staying the course and rebalancing, they not only missed an investment opportunity of a lifetime, but permanently locked in losses. Even some of the largest and most sophisticated investors sold assets at the bottom and went to cash. Some investors, especially underfunded pension plans, will never have enough time to recover from these mistakes.
It wasn’t a failure of IQ that doomed these investors. It was the inability to manage their emotions. If investors need to improve anything, it’s their rationality and temperament. Unfortunately, most investors are blind to the notion that they need help on their emotions. It’s an overconfidence and ego issue. Even investors who made every wrong decision during the 2009 financial crisis still blame the market or the government for their losses. Until they accept responsibility, they will continue to repeat these same mistakes.
Carefully Consider How You Allocate Your Time and Attention
Investors need to focus their mental energy in the right direction. Investors waste time trying to do impossible things- guessing where the market is going in the short-term, guessing the next economic news release, charting the markets, speculating in assets they don’t understand, etc. The amount of brilliance that is wasted on ineffective activities is astounding. It’s not just the average retail investor trapped by this behavior. Market professionals play the wrong game and lock themselves into a cycle of trying to predict impossible things.
The most important thing for us is to be extremely cautious as we allocate our time and energy. It’s a distracting world. Most of what gets reported as news is unimportant, distracting, and ultimately worthless. We fail to deliberately think about where we spend our time. It’s hard to avoid the seduction of the 24/7 news cycle. It traps us with intriguing story lines, delivered as if critically important to our investing success.
A rule of thumb – the more difficult the information to consume, the more valuable it is. For example, reading a 10-K is not an easy or light-hearted endeavor, but it’s probably one of the most worthwhile documents an investor can read. But it’s a long, tough read. Some 10-K’s are hundreds of pages long. But that’s where the critical detail sits. That’s where we develop the deep understanding of our investments and what price we should pay for them.
Many investors instead prefer CNBC and Twitter to catch investment headlines. This leads to a superficial, misleading understanding of our investments. It’s certainly a lot more fun but adds zero value to our process.
Objectivity, not Fate, Determines Investment Success
Investors do best when they view markets with a rational, objective lens. Investors who believe in fate, predetermined destiny, or divine intervention in the markets will always struggle to succeed. Because we don’t know exactly how the future will unfold, we need to think in terms of probabilities over many different future states of the world. It’s not a natural thought process and most investors just want a simple answer. Should I buy or sell? Is the market going up or down? They struggle to handle the uncertainty of the future, so they create a false sense of understanding and control by burying any notion of uncertainty.
We have control over a few things – our commitment to constantly improving our investment process, understanding the investments we own, and seeing the world through a rational and honest perspective. If we can do that, we can handle the future just fine. But if we can’t control our emotions, we will become frustrated when we consistently make poor investment decisions.