The 90% Rule: Making Better Investments with Less Anxiety

A Nonessentialist approaches every trade-off by asking, “How can I do both?” Essentialists ask the tougher but ultimately more liberating question, “Which problem do I want?” An Essentialist makes trade-offs deliberately. She acts for herself rather than waiting to be acted upon. As economist Thomas Sowell wrote: “There are no solutions. There are only trade-offs.”

You can think of this as the 90 Percent Rule, and it’s one you can apply to just about every decision or dilemma. As you evaluate an option, think about the single most important criterion for that decision, and then simply give the option a score between 0 and 100. If you rate it any lower than 90 percent, then automatically change the rating to 0 and simply reject it. This way you avoid getting caught up in indecision, or worse, getting stuck with the 60s or 70s. – Essentialism, George McKeown

In his book, Essentialism, George McKeown illustrates the benefits of deliberately making trade-offs to build a better and more “essential” life. His 90% rule consciously directs our focus and energy by eliminating decisions that fall below 90%. Logically, this means eliminating many good ideas that we would normally pursue. Why would we do that?

We rarely consider the negative effects of chasing all the good/average/mediocre decisions because we don’t consciously track the unintended consequences. It seems worthwhile until we consider the full cost of our actions. We pursue too many good decisions instead of focusing on a few great ideas. Chasing too many decisions leads to never-ending distractions and an overwhelming sense of “busyness”.

In today’s environment, investors have the same problem. By chasing hundreds of news stories, ideas, and recommendations, we end up distracted, overwhelmed, and ultimately ignorant. We don’t invest the energy in mastering the important principles. Consequently, we unknowingly make poor investments without realizing it until it’s too late. We feel like we should always be doing something – making a trade, firing a manager, or reading a headline. There is a perpetual action bias as patience is viewed with scorn. In an upward market, investors don’t have the patience to sit in safer assets. One of the worst things an investor can do is lose patience and settle for poor opportunities.

The 90% rule makes us slow down and consciously consider our ideas. Great investors aren’t trading every day. They have a few big ideas per year. That’s it. The notion that we need come up with exceptional ideas every week is unrealistic and leads to mindless activity. Investing is a game of quality, not quantity. We only need a few great investments over the course of many years to deliver exceptional results. We need to raise our standards when we take on risk to ensure we are adequately compensated for doing so. When we abandon that principle, we have little margin of safety when things don’t work out as we expected. The 90% rule isn’t perfect, but it avoids the marginal ideas that often get us in trouble. The 90% rule would stop a lot of bad investments. Because of our bias to settle for good ideas, our portfolios end up stuffed with marginal investments, instead of a high conviction, best ideas portfolio.

“Hell Yeah or No”

Entrepreneur Derek Sivers created the same rule to decide his commitments and areas of focus. He calls it the “Hell Yeah or No” rule.

Derek explains -

Use this rule if you’re often over-committed or too scattered. If you’re not saying “HELL YEAH!” about something, say “no”. When deciding whether to do something, if you feel anything less than “Wow! That would be amazing! Absolutely! Hell yeah!” — then say “no.” When you say no to most things, you leave room in your life to really throw yourself completely into that rare thing that makes you say “HELL YEAH!”. Every event you get invited to. Every request to start a new project. If you’re not saying “HELL YEAH!” about it, say “no”. We’re all busy. We’ve all taken on too much. Saying yes to less is the way out. -

Derek emphasizes that anything less than a “Hell Yeah”, is a “No”. Does that mean rejecting perfectly good ideas? Absolutely. We need give up the good opportunity today to capture the exceptional opportunity in the future. Adopting this rule makes life easy and delivers better results. The more we agonize over a good idea, the more time and energy we waste. It seems painful in the moment to reject a good idea. Remember, exceptional investments, just like ideas, are not evenly distributed – they come in bunches, waves, and clusters. Just because we don’t see a compelling investment today, we shouldn’t force the issue and trap ourselves in an average idea. If we’ve invested everything we have in good ideas, there is nothing left for the great ideas.

Buffett’s 90% Rule

Warren Buffett says it best. He talks about waiting for the fat pitch – waiting for the odds to be heavily tilted in our favor before investing. Here’s an excerpt from his 1997 Annual Letter -

Under these circumstances, we try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his "best" cell, he knew, would allow him to bat .400; reaching for balls in his "worst" spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.

If they are in the strike zone at all, the business "pitches" we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun.

When we can't find our favorite commitment -- a well-run and sensibly-priced business with fine economics -- we usually opt to put new money into very short-term instruments of the highest quality. Sometimes, however, we venture elsewhere. Obviously we believe that the alternative commitments we make are more likely to result in profit than loss. But we also realize that they do not offer the certainty of profit that exists in a wonderful business secured at an attractive price. Finding that kind of opportunity, we know that we are going to make money -- the only question being when. With alternative investments, we think that we are going to make money. But we also recognize that we will sometimes realize losses, occasionally of substantial size.-

“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot,” Buffett has said. “And if people are yelling, ‘Swing, you bum!’ ignore them.”-

Because of institutional mandates, competitive pressures, and ingrained bad habits, investors swing at bad pitches. Investors must keep up with other investors because if they lag behind, they are fired. Investment committees, boards of directors, and clients want their money managers to “do something”, especially if other investors are making money. After all, why pay them to sit around and do nothing? It doesn’t take managers too long to understand they better start swinging at pitches, even if they are constantly striking out.

How can we overcome this? It’s not easy. We need to embed patience in our process. Get comfortable waiting, and waiting, and waiting. The ability to invest independently and at the right time/price is critical. Investors can’t be evaluated like a factory worker. You can’t measure investment productivity by looking at activity, action, or output. Superior investing is about capturing rare opportunities, not about how many trades we make. In fact, the more decisions we force ourselves to make, the worse the outcome. Fewer decisions done better.

In expensive markets, it’s challenging to find homerun ideas. It’s a natural consequence of high-priced markets. It doesn’t mean that investors stop looking for ideas. There are always mispriced assets, no matter the level of the general markets. They are just harder to find. More importantly, preparation today equips investors to make homerun investments when those opportunities arise.

The worst thing an investor can do is give up on the 90% rule and settle for mediocre ideas. It’s tough to remain patient when the markets continue to hit all-time highs. The fear of missing out is real.

Charlie Munger’s Advice

Charlie Munger, Warren Buffett’s business partner, explains another variation of the 90% rule - Buffett’s 20 punch rule.

Here’s Charlie from his USC Commencement Speech -  

So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other. And you're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple. [emphasis mine]

When Warren lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all.”

He says, “Under those rules, you'd really think carefully about what you did and you'd be forced to load up on what you'd really thought about. So you'd do so much better.”

Again, this is a concept that seems perfectly obvious to me. And to Warren it seems perfectly obvious. But this is one of the very few business classes in the U.S. where anybody will be saying so. It just isn't the conventional wisdom. -

Treat your investments as sacred – more money is lost by getting into bad ideas than it is by missing out on good ideas. It’s easy to take a good idea and fool ourselves into thinking it’s a great idea. The 90% rule demands complete self-honesty. Remember, investments that meet the 90% rule are rare. It’s not easy to find exceptional opportunities. If we constantly find a lot of 90% ideas, we need to stop and think about how realistic and honest we are with ourselves. The higher the honesty, the more likely we will make wise investments. By following the 90% rule, we raise our investing standards, build a greater margin of safety, and can swiftly navigate an unpredictable future.



6 Investment Principles That Transform Fear & Uncertainty into Opportunity

Investing is all about the future. We invest cash today with an expected but ultimately uncertain amount of cash to be received in the future. The problem with the future is it’s largely unpredictable. Sure, we do our best to estimate and forecast what will happen, but ultimately, we invest in unknown and uncertain environments.

In a 2006 paper, Investing in the Unknown and Unknowable, Richard Zeckhauser described the challenges and opportunities of investing in unknown and unknowable environments. It’s a powerful article that explains why:

1.       Investors are overconfident in their ability to predict the future.

2.       Investors are reactionary and respond poorly to uncertainty and ambiguity.

3.       Investors should view the unknown as an opportunity, not a threat.

An uncertain future isn’t predictable, but we can prepare. Major investing mistakes occur at the extremes – whether a deep financial crisis or unconstrained market highs. Ambiguous and uncertain environments magnify poor decisions. These environments cause us to lose our rational, logical thoughts and rely on our primal, reactionary mental instincts. They goal is to understand how our mind reacts to unknown situations and design ways to turn these situations into opportunity. In essence, we should focus on preparing for uncertainty, not predicting uncertainty.

Investors should consider the following six lessons to help reframe unknown environments from fear to opportunity. As Richard stated, “Though investments are the ultimate interest, the focus of the analysis is how to deal with the unknown and unknowable.” Understanding the basics of the unknown allows us to make better decisions with less mental anguish. This can apply beyond investing to everyday life.

Principle #1: Understand When Traditional Financial Theory Fails

The essence of effective investment is to select assets that will fare well when future states of the world become known. When the probabilities of future states of assets are known, as the efficient markets hypothesis posits, wise investing involves solving a sophisticated optimization problem. Of course, such probabilities are often unknown, banishing us from the world of the capital asset pricing model (CAPM), and thrusting us into the world of uncertainty.

The real world of investing often ratchets the level of non-knowledge into still another dimension, where even the identity and nature of possible future states are not known. This is the world of ignorance. In it, there is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance. -Zeckhauser’s Investing in the Unknown and Unknowable.

Traditional financial theories work well in normal environments, but break down at the extremes. It’s our preparation for extremes that enables us to navigate uncertain waters. Proper investing at extremes has more to do with emotional intelligence than financial expertise. It’s about making gut-wrenching decisions during financial chaos or irrational optimism. In theory, you should be following the same basic prudent investing rules regardless of the environment: rebalancing to your target portfolio, managing your liquidity and cash flows, and examining your risk profile. In a crisis, prudent behavior disappears as typical financial relationships break down. Our decision making becomes a random assortment of knee-jerk reactions and emotionally-fueled urges.

The practical solution is to first accept these situations will occur. Don’t stick your head in the sand. We can’t predict the causes or magnitudes of extreme events. But while prediction fails, preparation advances. We can prepare by understanding the investments we own so we can overcome our emotions and regain long-term, logical thinking. We can run through scenarios and stress our portfolio to extremes to figure out how much pain we can handle.

Finally, we can study historical events and learn lessons from other great investors who went through similar situations. There are two benefits. First, it’s comforting to know the best investors have gone through the same pain and faced the same impossible decisions that we will face. Second, we can actually borrow these investor’s techniques and tools for our own use. Many great investors lay out exactly how they approach unique situations. We can build a library of principles to help guide us during uncertain environments.

The second dreary conclusion is that most investors – whose training, if any, fits a world where states and probabilities are assumed known – have little idea of how to deal with the unknowable. When they recognize its presence, they tend to steer clear, often to protect themselves from sniping by others. But for all but the simplest investments, entanglement is inevitable – and when investors do get entangled they tend to make significant errors. -Zeckhauser’s Investing in the Unknown and Unknowable.

Ignoring the unknown is not an acceptable strategy. Delaying the recognition magnifies future errors. These errors can eliminate years of sound investing during normal times.

Remember the 2009 financial crisis. Investors who had done everything right up until then were caught off guard with the severity of the crisis. Many investors had excessive amounts of risk going into the crisis, and then compounded the problem by going to cash at the bottom. It’s not that investors forgot the basics of investing. It’s that they didn’t prepare for the “entanglements” in advance, so investors weren’t ready to make better choices.

Principle #2: To Capture Excess Investment Returns, Study The Unknown/Unknowable

Such idiosyncratic UU [unknown and unknowable] situations, I argue below, present the greatest potential for significant excess investment returns.

The first positive conclusion is that unknowable situations have been and will be associated with remarkably powerful investment returns. The second positive conclusion is that there are systematic ways to think about unknowable situations. If these ways are followed, they can provide a path to extraordinary expected investment returns. To be sure, some substantial losses are inevitable, and some will be blameworthy after the fact. But the net expected results, even after allowing for risk aversion, will be strongly positive. -Zeckhauser’s Investing in the Unknown and Unknowable.

Exceptional opportunities occur in volatile environments. These unknown and unknowable (Zeckhauser refers to them as “UU”) situations, can deliver significant opportunities. Investors scared of big price moves won’t have the fortitude to handle the occasional misses. Remember, the goal is to grow the total portfolio value over time. How many misses you have isn’t the important variable; it’s the totality and magnitude of your wins and losses that matter. Those who prefer no losses at all, often sacrifice significant total return growth verses investors who can handle some losses but allow their successful investments to more than compensate for those losses.

There is nothing wrong with a conservative, diversified portfolio that avoids higher return/higher risk investment situations. It’s important to understand where you have an advantage and where you don’t.

However, investors who excessively try to avoid volatility and uncertainty often buy and sell at the worst possible times, locking in losses to avoid mental pain.

Do not read on, however, if blame aversion is a prime concern: The world of UU is not for you. Consider this analogy. If in an unknowable world none of your bridges fall down, you are building them too strong. Similarly, if in an unknowable world none of your investment looks foolish after the fact, you are staying too far away from the unknowable. -Zeckhauser’s Investing in the Unknown and Unknowable.

Investors’ excessive desire to avoid looking foolish punishes their future returns. For example, it’s always hard to buy near the bottom since the trend looks so bad and the news flow is negative. And because investors tend buy early, they will certainly look foolish in the short term. This apparent foolishness compounds the already challenge of capturing exceptional opportunities. The ego’s desire to avoid looking wrong in the short term causes huge long-term pain. Short-term, “foolish” decisions can often be the most profitable, because a little early pain is necessary to capture the biggest opportunities.

But it would be surprising not to see significant expected excess returns to investments that have three characteristics addressed in this essay: (1) UU underlying features, (2) complementary capabilities are required to undertake them, so the investments are not available to the general market, and (3) it is unlikely that a party on the other side of the transaction is better informed. That is, UU may well work for you, if you can identify general characteristics of when such investments are desirable, and when not. -Zeckhauser’s Investing in the Unknown and Unknowable.

Let’s examine the 3 characteristics –

1.       UU Underlying features – Most UU (again, shorthand for unknown and unknowable) situations are a result of previous excesses being unwound in a rapid fashion. This can be an erosion of asset value at financial institutions (2009 crisis) or a shift in commodity supply & demand causing rapid price declines (2015 oil collapse). There are constant factors leading up to these crises. Easy money in the form of cheap debt or plentiful capital for investment. Excessive enthusiasm. Embracing new valuation paradigms with no substance. These environments begin with reasonableness but end up at extremes due to extrapolation, momentum, inadequate risk consideration, and a disregard for mean reversion and competition. There is usually a claim that this time is different.


2.       Complementary Capabilities – These capabilities refer to an investor’s ability to correctly analyze a UU situation. Although there is no guarantee of success, great investors have a few key attributes that convert a UU situation into a wise investment. First, they have the correct mental makeup and behavior regulation that enables logical and emotion-free analysis. Nothing is harder than trying to keep your head when a market is collapsing. Great investors acknowledge the uncertainty and emotion, but quickly engage their higher cognitive powers to establish agency over the situation. Highly complex investments don’t lend themselves to casual analysis by unprepared investors.


Second, they are subject matter experts on the specific market or security. Successful investing is not about blind investing into UU situations. Mean reversion works on average, but there is enough variation around the average which allows investors to blow up their portfolio. You don’t have to become the most knowledgeable and obtain a Ph.D, but you must know enough the tilt the odds in your favor. Not all investments that price at bargain levels will make it, and a few zeros can destroy your portfolio or cause you to lose faith in your process at the moment you need it most.

Finally, successful UU investors focus on risk control. Risk control is not about avoiding risk. Risk control is about thoughtfully approaching your portfolio with a sense of humility that offsets the natural tendency to overinvest or overconcentrate. Humility checks your ego and spreads your risk among several very attractive investments, rather than focus on one or two high conviction names. Well-known investors have been burned by overconfidence in their top ideas. When these go bad, they lose more than they can ever recover. Investing is always uncertain and unpredictable, and overconfidence will trap even the best investors.

3.       Information Asymmetry

Investors should pay close attention to the other investors in the market. If the situation favors the other side of the trade because they have an informational advantage, investors will likely lose. In some markets, such as IPOs, M&A transactions, art investing, etc, sophisticated/specialized investors will have a significant advantage. These markets are highly competitive and leave most investors as the sucker. However, UU situations are different. They are avoided because of the psychological pain and uncertain environment. All investors generally have the same informational level.

Principle #3: Judgment, Not Intelligence, Distinguishes Great Investors

Alas, few of us possess the skills to be a real estate developer, venture capitalist or high tech pioneer. But how about becoming a star of ordinary stock investment? For such efforts an ideal complementary skill is unusual judgment. Those who can sensibly determine when to plunge into and when to refrain from UUU investments gain a substantial edge, since mispricing is likely to be severe. -Zeckhauser’s Investing in the Unknown and Unknowable.

Judgement determines whether our investing intelligence is converted into money-making investments. Intelligence needs to be applied to the correct asset, at the correct price, at the correct time. Lots of smart, sophisticated investors execute poorly. For example, they buy good assets at the wrong price. They let emotions and hubris interfere with great thinking and end up buying or selling at the wrong time or in the wrong markets.

Note, by the way, the generosity with which great investors with complementary skills explain their successes – Buffett in his annual reports, Miller at Harvard, and any number of venture capitalists who come to lecture to MBAs. These master investors need not worry about the competition, since few others possess the complementary skills for their types of investments. -Zeckhauser’s Investing in the Unknown and Unknowable.

It’s an interesting thought – does Warren Buffet or other great investors fear giving away their secrets? No. They know the right combination of intelligence, temperance, humility, sound judgment, and courage may take decades to develop. Investors can’t turn on this ability when they want. It’s a mindset that needs deep cultivation and a lifetime of practice.

Principle #4: Overcoming Investor Biases Requires Thoughtful & Deliberate Training

Behavioral decision has important implications for investing in UU situations. When considering our own behavior, we must be extremely careful not to fall prey to the biases and decision traps it chronicles. Almost by definition, UU situations are those where our experience is likely to be limited, where we will not encounter situations similar to other situations that have helped us hone our intuition. -Zeckhauser’s Investing in the Unknown and Unknowable.

UU situations are not won by accumulating more facts or having a bigger spreadsheet. In these environments, there is an irreducible amount of uncertainty, no matter how much work and effort is applied. Clearly, you need to do your homework before investing. But many investors have the false idea that they can get rid of all uncertainty. They fool themselves with blind overconfidence. Our mind’s natural tendency is to eliminate any apparent uncertainty, through the stories we tell ourselves or our selective analytical approaches. UU situations require analysis and work, but ultimately success comes down to making a tough decision when the probability is deeply in your favor.

There are too many investor biases and mistakes to list here, but the important takeaway is to get comfortable with uncertainty. It’s a natural condition of successful investing. The goal is not uncertainty elimination, but uncertainty acceptance and management. If you accept uncertainty, you transform your outlook on uncertainty from a situation to fear to a situation to exploit.

Principal #5: Invest Where Others Neglect

The major fortunes in finance, I would speculate, have been made by people who are effective in dealing with the unknown and unknowable. This will probably be truer still in the future. Given the influx of educated professionals into finance, those who make their living speculating and trading in traditional markets are increasingly up against others who are tremendously bright and tremendously well-informed. -Zeckhauser’s Investing in the Unknown and Unknowable.

Just as in business, it often pays to invest in assets neglected by the competition. Fast growing ideas attract significant capital, reducing the expected returns and raising the risk profile. Investors who are late to the party will end up with higher risk and lower returns. For most investors, they are unlikely to be the first movers or early followers. They will arrive late, invest at the peak, and suffer significant losses.

The antidote is to go where there is less competition, little excitement, and significant uncertainty. These factors drive most investors away and create mispricings as prices significantly deviate from fundamentals.

Even sophisticated investors are likely to shy away from these areas.

First, their clients expect and prefer lower volatility and consistent returns, rather than volatile but higher returns. Clients want a smooth ride, and don’t tolerate excessive volatility from even the best managers.

Second, manager themselves feel pressure to gravitate towards opportunities that have a compelling narrative. Narrative-based investments are an easier sell to internal management and the public because they sound so good and have often performed well. But these attributes don’t correlate with future success, as competition and mean reversion often reverse any positive momentum and derail the narrative.

Finally, investments that appear certain today will often become uncertain, and vice versa. Uncertainty isn’t a permanent characteristic of any particular asset class. Uncertainty ebbs and flows based on investor emotions and economic conditions. Today’s uncertain areas may become more predictable as industries and companies adjust and adapt to new environments.

Because these environments are fluid and dynamic, they are always working toward an equilibrium condition. For example, when companies go bankrupt, those bankruptcies often give the remaining companies a stronger competitive position, higher market share, and a bigger share of the profits. So the conditions that cause uncertainty will usually correct itself as the markets and competitive economies adjust to new realities.

If you understand this process, you can be forward thinking and have a reasonable idea how these industries will evolve, even when it seems that the pain or uncertainty is unmanageable.

By contrast, those who undertake prudent speculations in the unknown will be amply rewarded. Such speculations may include ventures into uncharted areas, where the finance professionals have yet to run their regressions, or may take completely new paths into already well-traveled regions.

Similarly, the more difficult a field is to investigate, the greater will be the unknown and unknowables associated with it, and the greater the expected profits to those who deal sensibly with them. Unknownables can’t be transmuted into sensible guesses -- but one can take one’s positions and array one’s claims so that unknowns and unknowables are mostly allies, not nemeses. And one can train to avoid one’s own behavioral decision tendencies, and to capitalize on those of others. -Zeckhauser’s Investing in the Unknown and Unknowable.

Avoid depending on ultra-precise analysis as an attempt to remove uncertainty. The goal is to get close enough in your understanding of the situation to make an educated guess and position accordingly. Investors comforted by false precision are usually wasting time or fooling themselves.

Principle #6: Bet According To Your Advantage; But First Be Honest About Whether You Really Have An Advantage

…The greater is your expected return on an investment, that is the larger is your advantage, the greater the percentage of your capital you should put at risk…Most investors understand this criterion intuitively, at least once it is pointed out. But they follow it insufficiently if at all. The investment on which they expect a 30% return gets little more funding than the one where they expect to earn 10%. Investment advantage should be as important as diversification concerns in determining how one distributes one’s portfolio. -Zeckhauser’s Investing in the Unknown and Unknowable.

There should be some obvious intuition that higher conviction ideas with less risk and higher expected returns should have bigger positions in your portfolio.

In principle, I agree with that assessment. But there is a major assumption underlying this idea that must be true for this to work:

Do you actually have an advantage?

How do you know?

How do you know if you have correctly analyzed, vetted, and arrived at the correct conclusion?

What if you are just overconfident and mistaken?

How would you know until it’s too late?  

Anecdotally, I have heard several investors proclaim an investment as their #1 idea, only to see it actually end up as one of the worst ideas. I don’t believe an investor’s conviction level translates into above average returns. In fact, there may be an inverse correlation between the two. Anyone can pitch a compelling idea that promises all upside and no downside. It doesn’t mean it will happen.

If the difference between two ideas is significant enough, they should have different portfolio weights. But again, this all rests on the ability of the investor to be well calibrated to know when these differences really exist and when they are false.


Two rays of light creep into this gloomy situation: First, only rarely will his information put you at severe disadvantage. Second, it is extremely unlikely that your counterpart is playing anything close to an optimal strategy. After all, if it is so hard for you to analyze, it can hardly be easy for him. -Zeckhauser’s Investing in the Unknown and Unknowable.

As a final reminder, most investors you compete with are not playing an optimal strategy. Most are struggling, trying to figure out the best move in a complicated and uncertain world. Especially in periods of extreme stress, investors are likely to be on edge, forgetting the basic investing tenants and relying on emotion and gut feeling. By contemplating these principles, you have taken the initial steps to properly execute in the right investment situations. To be sure, you won’t get every decision correct. And yes, you may end up trading across from Warren Buffet or some elite hedge fund. But those situations will be the minority, especially if you adhere to these principles when thinking about the unknown and unknowable.

If you acknowledge and embrace the unknowable, you are better equipped to handle reality as it is – uncertain and unpredictable. By using wise judgement and training to overcome your inherent misconceptions, you outperform competing investors by leveraging your circle of competence and understanding when to make appropriate bets.

The 6 Principles in Review:

Principle #1: Understand When Traditional Financial Theory Fails

Principle #2: To Capture Excess Investment Returns, Study The Unknown/Unknowable

Principle #3: Judgment, Not Intelligence, Distinguishes Great Investors

Principle #4: Overcoming Investor Biases Requires Thoughtful & Deliberate Training

Principal #5: Invest Where Others Neglect

Principle #6: Bet According To Your Advantage; But First Be Honest About Whether You Really Have An Advantage

The Influence of Crowd Psychology on the Investor

In 1895, Gustave Le Bon published his best-known work, The Crowd: A Study of the Popular Mind. At the time, Le Bon enhanced the understanding of crowd psychology by researching and proposing several theories of how our beliefs and actions are altered in a “crowd” state.

How can a book from 1895 be useful to investors today? The basic idea is that our minds have not changed over the last 100 years. We still respond to the same emotions and biases as our ancestors. We repeat the same mistakes, generation after generation.

The influence of the crowd has never been more relevant. We must protect our mind from the opinions and ideas we accept. The information deluge is constant. It’s a fuzzy, almost imperceptible line to separate our own opinions from the opinions of the masses. That battle is consistently lost by unprepared investors who let their guard down when making investment decisions. 

Because we, as humans, are susceptible to overconfidence, we assume the crowds have no influence on our mind. We are too confident - it’s always other people’s problem, not ours. We are way too smart to be influenced by crowds.  I wish that were true, but studies clearly indicate otherwise.

How do we fight against becoming the “crowd” and learn to combat the frivolous and dangerous ideas?

Based on Le Bon’s work, I have created 8 lessons to prepare your mind against crowd behavior. (Note: all quotes attributable to Le Bon’s work, The Crowd)

It’s not an easy or painless endeavor. As Le Bon stated, “Science promised us truth, or at least a knowledge of such relations as our intelligence can seize: it never promised us peace or happiness.”

Understanding crowd psychology is not comfortable. We might not like the journey, but ignoring science dooms us to forever remaining in the crowd.

1.       The Struggle to Maintain Independence

It is only by obtaining some sort of insight into the psychology of crowd that can be understood how slight is the action upon them of laws and institutions, how powerless they are to hold any opinions other than those which are imposed upon them, and that it is not with rules based on theories to pure equity that they are to be led, but by seeking what produces an impression on them and what seduces them.

The goal is to understand how a crowd imposes its will on our minds. The first step is always understanding the process. The second step is creating a habit or framework to counter crowd effects.

We see that the disappearance of the conscious personality, the predominance of the unconscious personality, the turning of feelings and ideas in an identical direction by means of suggestion and contagion, the tendency to immediately transform the congested ideas into acts. These receive the principal characteristics of the individual forming part of a crowd. He is no longer himself, but has become an automaton who has ceased to be guided by his will.

Whenever we self-identify with a crowd, whether consciously or unconsciously, we strip away our ability to remain objective and rational. It’s evident in politics and religion. Ever try to have a logical political or religious debate? How quickly did it devolve into an anecdotal argument full of personal attacks and red herrings? Most people quickly move into defensive positions and start to defend their identities, rather than the argument. Once that happens, all reason disappears and no progress is made.

The crowd is at the mercy of all external exciting causes, and reflects their incessant variations. It is the slave of the impulses which it receives. Isolated individuals may be submitted to the same exciting causes as a man in a crowd, but as his brain shows him the in advisability of yielding to them, he refrains from yielding. The truth may be physiologically expressed by saying the isolated individual possesses the capacity of dominating his reflex action, while crowd is devoid of this capacity.

Remember, the crowd doesn’t seek the truth; it’s in constant search of excitement, novelty, and reward. If you understand that, you are prepared to understand events with a free mind. By remaining outside the crowd, you retain your capacity to evaluate the situation independently.

It’s never a problem to agree with the crowd, as long as you come to that decision through independent means. And doing that is never easy.

2.       Excitement and Novelty Drive Belief

The exciting causes that may act on crowds been so buried, and crowds always opening them, crowds are in consequence extremely mobile. This explains how it is that we see them pass in a moment from the most bloodthirsty ferocity the most extreme generosity and heroism.

When financial crowds operate in extreme directions, the market moves defy logic. What excited a crowd one day is erased with a terrifying reversal in sentiment the next day. These actions are unpredictable and wild. Although we try in vain to understand what is happening, it’s sufficient to attribute these moves to crowd behavior. Don’t waste time and energy trying to dissect the “meaning” of what these moves mean. There is no meaning, other than investors are all behaving under the spell of crowd psychology. While other factors, like leverage, enhance these effects, the root cause is always the crowd on one side of the trade.

They may be animated in succession by the most contrary sentiments, but they will always be under the influence of the exciting causes of the moment…Still, though the wishes of crowds are frenzied they are not durable. Crowds are as incapable of willing as of thinking for any length of time.

On the positive side, the extreme swings don’t last. Fundamentals eventually matter, and the crowds that operate irrationally eventually run out of assets to sell or run out of money to buy. The best course of action is remaining patient and vigilant. These are the opportunities to take advantage of the crowd, by using their instability against them.

3.       Crowd Beliefs Shut Down Thinking

A crowd is not merely impulsive and mobile. Like a savage, it is not prepared to admit that anything can come between its desire and the realization of its desire. It is less capable of understanding such an intervention, a consequence of the feeling of irresistible power given it by its numerical strength. The notion of impossibility disappears from the individual in a crowd.

Investors during the 2000 tech bubble and the 2006 housing bubble understand why the notion of impossibility disappears from the investment crowd. During those bubbles, tech and housing assets were viewed as can’t miss opportunities, and no amount of rational thinking could prevent investors from believing it was different this time. These assets couldn’t fail because of new paradigms, due to the Internet emergence in 2000 or the unending real estate boom in 2006. Owning these assets and watching them rise reinforced the belief that these assets couldn’t go wrong. But they did, and in a big way.

The improbable does not exist for crowd, it is necessary to bear the circumstance well in my to understand the facility with which are created and propagated the most improbable legends and stories…The simplicity and exaggeration of the sentiments of crowds have for result that a throng knows neither doubt nor uncertainty.

Legends and stories, not facts and data, drive investment booms and busts from healthy to extreme. It’s the stories that convince us of the invincibility and permanence of new ideas. During a bull market, our minds run wild with the possibilities of fantastic gains and newfound wealth. During a crisis, we believe everything is going to zero and assume permanent financial destruction.

The commonality behind both situations is our reliance on stories, rather than relying on factual research and historical lessons. We quickly dismiss any logical approach, because we’ve attached our opinions to the movement of the crowd.  

Whether the feelings exhibited by a crowd be good or bad, they present the double character being very simple and very exaggerated. On this point, as on so many others, and individual in a crowd resembles primitive beings.

We become primitive, in the sense we abandon our developed cognitive processes and let our reptilian brain direct our actions. Our primitive brain was well-designed for living 2,000 years ago, but has not adapted to the modern financial world. Because fear and greed operate on our basic, primitive minds, we must deliberately engage our higher cognitive mind to think clearly.

4.       Emotion Dominates Facts and Evidence

An individual may accept contradiction and discussion; a crowd will never do so.

The chain of logical argumentation is totally incomprehensible to crowds and for this reason is permissible to say that they do not reason or that they reason falsely and are not to be influenced by reasoning.

Crowds dismiss all alternative explanations and contradictory evidence. There are excuses for everything, and no amount of facts or reason will persuade a crowd.

Evidence may be accepted by an educated person, but the convert will be quickly brought back by his unconscious self to his original conceptions. See him again after the lapse of a few days and he will put forward a fresh his old arguments and exactly the same terms.

We can educate, train, and then educate some more, but still never escape the grasp of the crowd. It takes persistent training to re-wire our brains to instinctively recognize and fight the influence of the crowd. It doesn’t happen overnight.

I’ve personally experienced and seen others attempt to change behavior by just adding more information and assuming that will change behavior. Because our behavior is based on cognitive processes evolved over millennia, it’s going to take more than new info to make the change. It’s about using new info to transform habits into permanent behavior change.

That’s why you see investors make the same, repeated mistakes. We can spend all day convincing people of one thing, only to have them revert back a day later. The reason is two-fold. It’s the brain’s way of resisting change and reflects our ill-designed attempts to convert behavior. Permanent, long-term behavior modification requires repeated exposure to live training. Anything else is futile.

A longtime is necessary for ideas to establish themselves in the minds of crowd, but just as long a time is needed for them to be eradicated. This reason crowds, as far as ideas are concerned, are always several generations behind learned men and philosophers.

When we think of “learned men and philosophers” within investing or business, we gravitate toward the those who have proven their investing acumen over decades. JP Morgan, John Rockefeller, Andrew Carnegie, Ben Graham, Warren Buffet. All exceeded their generation by operating outside of the normal crowd state. The goal is to incorporate the lessons of the historic greats and operate with different principles than the crowd. It’s not enough to know different information. We must operate with a different set of principles than the crowd: independence, grit, intelligence, foresight, contrarianism, and persistence.

It is not than the facts and themselves that strike the popular imagination, but the way in which they take place in our brought under notice. The epidemic of influenza may very little impression on the population because they happened a little at a time, as opposed to one giant event that would’ve caused an uproar among the population.

The hardest beliefs to challenge can be the most non-obvious. Incorrect beliefs that have been learned gradually often lack the vividness that would normally cause us to re-examine those beliefs.

5.       Strong Beliefs are Fine, But be Open to Change

A person is not religious solely when he worships a divinity, but when he puts all the resources of his mind, the complete submission of his will, and the whole sold ardor of fanaticism at the service of a cause or an individual becomes the goal and guide of his thoughts and actions.

It’s fine to have beliefs, and strong beliefs at that. But all beliefs need at least 3 qualities:

1.       Evidenced based – valid, fundamental data should support your beliefs. Data is not always perfect and is never guaranteed, especially when thinking about the future. But there is no room for mythical or untested beliefs to drive investing decisions.

2.       Open to modification or reversal – strongly held beliefs should be changed when the weight of the evidence tips to the side of change. Beliefs should be held tentatively, ready to be changed when sufficient data/evidence is presented. Some beliefs may change daily (for example, because prices move daily, what is a terrible deal at one price is a great deal at another price) or may be rarely change (the idea that investing and saving for the future is a good thing). There’s no easy answer to this, other than to evaluate each belief on its own when new evidence is presented.

3.       Separate beliefs from your identity – if you attach beliefs to your identity, personality, or other personal trait, you run the risk of keeping beliefs not because they are correct, but because you become more interested in defending your ego and reputation. For example, if you always self-identify as bullish and optimistic on the stock market, it’s challenging to change your mind when the market is overvalued, because you have created a reputation and identity as someone who is perpetually bullish. It’s hard to have the guts to change your mind when your identity is something else.

You’ve created cognitive dissonance when your identity is telling you one thing (buy stocks) and the evidence is telling you another (sell stocks). The identity almost always wins, because our minds have a bigger interest in protecting our identity than searching for the truth. This is deadly for investors. Don’t take permanent stances in investing. Don’t create reputations or identities that make it painful to change your mind.

The masses have never thirsted after truth. They turn aside from evidence that is not to their taste, preferring to deify error, if error seduced them. Whoever can supply them with delusions is easily their master, whoever attempts to destroy their illusions is always their victim.

Many investors are eternally searching for the magic formula or guaranteed path to riches. They spend thousands of dollars on programs and systems that supposedly “reveal” the inside secrets of investment success. When viewed through a logical, rational lens, these claims are ludicrous and insane. But when viewed through the “crowd” lens, these programs make perfect sense. They appeal to investor’s desire for a can’t miss system, no matter how incredulous.

Investors must recognize when they fall under the spell of delusional, yet seductive systems that promise riches. It’s an inherent bias we all need to fight, and the minute we let our guard down, we succumb to our primal, crowd-based motives.

The experiences undergone by one generation are useless, as a rule, for the generation that follows, which is the reason why historical facts, cited with a view to demonstration, serve no purpose.

There are several reasons why investors forget the lessons of the past.

1.       We assume the people in the past were unsophisticated/unintelligent. We will never make those same mistakes. Wrong. While we have certainly advanced as a society, poor investing decisions in the past were usually never the result of a relative disadvantage in IQ or decision making. While we may know more today, we are also making decisions in a world that is more complicated and uncertain than it was in the past. In absolute terms, we may have an edge, but we are playing a more complex investing game. We are in a tougher environment, so we are relatively no better off.

2.       Hindsight is 20/20 – With the benefit of hindsight, we create all sorts of reasons why we wouldn’t have made those same mistakes. But it’s always obvious in retrospect, never in real-time. If you think it’s so easy, write down some can’t miss ideas today, and track those over a course of 3-5 years. Chances are you will have as many misses and wins, if not more misses. It’s a simple experiment to prove how hard it is to move hindsight into foresight.

3.       We assume the environment today is more predictable because we have access to more immediate information. Yes, we do have more information, and some of it is extremely valuable. However, that information comes with a lot of noise (data or information that has no predictive use or functional utility). And the catch is, it’s difficult to separate those two groups. We often get a mess of data and try to figure out what is news and what is noise. There’s never a clear answer, because what is useful in one environment is useless in another. You must be very clear about what edge you have and understand your circle of competence. Once you start to drift outside your core competence, you make all sorts of mistakes, including mistaking noise for news.

 6.       Understand the Psychological Tricks Preying on Your Mind

We’ve already discussed the problems dealing with unpredictable and complex investment situations. But there is even more trouble for us.

The financial industry promises to help investors navigate the complex investment world. Of course, they don’t expect to do that for free. It’s a lucrative industry that spawns many charlatans, con men, and promotors who want a slice of our wealth in exchange for bogus market-beating systems and hot stock tips.

These are both people and corporations full of bad advice and misdirection. To defeat them, you need know the tricks they play. Le Bon suggests several situations and triggers to watch for to understand when you are being pulled in the wrong direction.

We have already shown the crowd or not to be influenced by reasoning, and can only comprehend rough and ready associations of ideas. The orators who know how to make an impression upon them always appealing consequence to their sentiments and never to the reason. The laws of logic have no action on crowds.

The first idea: understand they always appeal to emotion, not reason. They sell with stories and dreams, not verified facts and evidence. If they based their approach on raw evidence, 1) their performance/client results look terrible, and 2) it does little to inspire wealth and riches when looking at cold numbers. They need to get you excited to get rich, or at least distract you from the flaws and risks in their argument. So always separate fact from story.

Given to exaggeration and its feelings, a crowd is only impressed by excessive sentiments. An orator wishing to move a crowd must make an abusive use of violent affirmations. To exaggerate, to affirm, to resort to repetitions, and never to attempt to prove anything by reasoning or methods of argument well known to speakers at public meetings.

It is terrible at times to think of the power that strong conviction combined with extreme narrowness of mine gives a man possessing prestige. It is nonetheless necessary that these conditions should be satisfied for man to ignore obstacles and display strength the will and a high measure. Crowds instinctively recognize and men of energy and conviction the Masters they are always in need of.

Two elements persuade a crowd. Strong conviction and extreme narrowness. Strong conviction delivers an overwhelming aura of superiority and challenges your ability to think independently, even if the conviction is baseless. Extreme narrowness reinforces that there is only one solution and path forward. It leaves no room for alternative explanations or doubt.

7.       How False Beliefs Spread

The first is that as the old beliefs are losing their influence to a greater and greater extent, they are ceasing to shape the ephemeral opinions of the moment as they did in the past. The weakening of general beliefs clears the ground for crop of haphazard opinions without a past or future.

As economic and investment cycles progress, investors abandon common-sense, fundamental principles and gravitate towards riskier, crowd-like behavior. There is always a rationale why the old beliefs don’t matter and the new ideas must be the new answer.

A second reason is that the power of crowds being on the increase, and this power being less and less counterbalance, the extreme ability of ideas, which we have seen to be a peculiarity of crowds, can manifest itself without let or hindrance.

As ideas spread, they build momentum and a cult-like power that begins to defy reason and logic. Unfortunately, these ideas don’t need any extra push when they start to spread. They build their own momentum through the explosive exponential power of networks.

8.       Why We are Doomed to Repeat Our Mistakes

Judging by the lessons of the past, and by the symptoms that strike the attention on every side, several of her modern civilizations have reached that phase of extreme old age which precedes decadence. It seems inevitable that all peoples should pass through identical phases of existence, since history is so often seem to repeat its course.

One of Le Bon’s final lessons is the idea that humans continue to repeat the same mistakes of the past. No matter how much we improve our understanding, intelligence, or technology, we have ingrained biases and tendencies that we can never permanently overcome. Due to laziness and ignorance, we assume these lessons don’t apply to us, because it’s so hard to create an outside, objective filter to view our own actions. Even though we can’t remove them, we can circumvent and avoid the consequences by deliberately understanding the underlying causes. The key word is deliberate, because just adding more information will not work. We need a conscious effort to understand the historical lessons and design ways of countering the effects of crowd-like behavior.

Dangerous Protest Threatens Harvard's Endowment

Just when the pressures on university endowments seem to abate, another misguided attempt to use endowments as a political weapon falls on Harvard. According to The Harvard Crimson and an article by Bloomberg’s John Lauerman, Hollywood stars, current students, and other activists are demanding Harvard’s endowment divest its holdings of fossil fuel investments. Protesters assert divesting will cut the use of fossil fuels and increase the use of alternative energy. How that would actually work is where the logic gets fuzzy. It’s a shame such a highly regarded institution can produce graduates who support such a misguided stunt. The protest lacks any coherent reasoning, threatens the objectivity of the endowment's staff, and paralyzes the investment decision making necessary for long-term success. Divestments are endemic of a trend to use headline-grabbing exploits instead of engaging in real constructive change.

No real effects...

Divestment of energy related investments have no negative effects on the companies. Managements are not going to change their corporate strategy and mission. Energy companies have dealt with critics for decades! Divesting simply sells the stakes to some other buyer. In the end, there is no real change in any of these transactions. The companies don’t lose any funding! Buyers and sellers trade all day without the company caring. It’s simply a smokescreen to persuade the unsuspecting Harvard community that something is being done. If protestors want to change something, how about producing some real innovation in the energy space that can help shift away from fossil fuels? Divestment tactics are a distracting and meaningless attempt to convince the public that change is occurring.

Invert, always invert...

In fact, protestors actually have it backwards! If they want to induce change, they should advocate increasing the stakes in fossil fuel companies! Higher ownership stakes enables shareholders to voice their opinions through proxy voting in favor of better environmental policies. It allows shareholders to confront company management and engage in real, substantive dialogue. Divestment accomplishes the opposite. It removes any chance to enable change by passing that responsibility onto someone else. Of course, I doubt protesters actually want to put that much work into this; it’s much easier to organize a sit-in!

Dangerous precedent...

Endowments are already under tremendous pressure from university leadership, faculty, and students to deliver above average investment returns to fund the facilities, professors, and students that make Harvard so great. What endowments don’t need are another set of backhanded and dubious mandates that distract investment staff from their real jobs. Harvard’s investment staff has one goal: to ensure the continued growth of the endowment, not to become a pawn in a political and environmental campaign.

As a former portfolio manager at a pension fund, I can felt the challenges of navigating the financial markets before dealing with interference by outside protesters. Pet projects like divestments undermine the investment process that Harvard has successfully built over the previous decades. Investment staff now have to consider if investments made today will someday be examined under a microscope, leading to second guessing the real mission of the endowment. The real victim in this divestment push is not the actual companies; it’s the students and alumni of Harvard who will realize fewer benefits and be asked to shoulder a higher burden for the university.

If protesters want curb the use of fossil fuels, they should start supporting alternative energy projects or fund their own energy startup. Unfortunately, they might find that real change requires hard work and deep commitment, not occupying a university building.