Today I’m writing about the most neglected yet important thing to successful investing -the command of investor psychology. Investing is one of the most complex and stressful activities we do. Most of us know the emotional toll investing takes when markets are volatile and unpredictable. Research from cognitive psychology, neuroscience, and behavioral economics has yielded the same insight: that not only do we make mistakes, but we make bigger and more frequent mistakes when under pressure. The resources that often try to help, like the media and professional investment advice, often end up compounding, rather than eliminating, the error.
Psychology is critical because we are human. We are not robots. We are not perfectly rational. We make mistakes. It’s especially in investing where we tend to make the same mistakes and exhibit the same poor behavior. We can document this behavior starting with the Dutch Tulip Bubble in the 1630s, all the way through the 2009 financial crisis, and now with the cryptocurrency bubble.
We need a different strategy to counteract the human tendency to screw up our investment process. Remember, no one can do this for you. Even if other people manage your money, you can’t outsource your thinking.
Ultimately it comes back to you: whether you control your emotions, or your emotions control you.
Howard Marks, the founder of Oaktree Capital, says it best:
“The superior investor resists psychological excesses and thus refuses to participate in these [emotional] swings. The vast majority of the highly superior investors I know are unemotional by nature. In fact, I believe their unemotional nature is one of the great contributors to their success.”
Likewise, Warren Buffett has a similar message:
"Success in investing doesn't correlate with I.Q. once you're above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble…" As much as anything else, successful investing requires something perhaps even more rare: the ability to identify and overcome one's own psychological weaknesses.”
This quote from Buffett describes the mission of this article: temperament and emotional control are essential for investing success.
Without these abilities, it’s hard to make better decisions under volatile and stressful environments. If you already have these traits, you can handle the market extremes and deal with the stress.
But what if you don’t have these natural abilities? Are you out of luck?
For a long time, the answer was yes. The common wisdom stated these traits were genetic and permanent. Recent research says something different. It turns out that even though we are generally predisposed to certain behaviors, these attributes can be changed and trained. Resilience, temperament, and emotional control are skills like any other – they are cultivated. The biggest impediment is the lack of direction the investment industry offers on how to actually train these skills.
The investment world likes to focus on hard skills – IQ, financial analysis, industry expertise, etc. Of course, those abilities are important, but only to a point. There is such a reliance on formulas, equations, and facts as the only solution for investors. It’s taught in school because it’s perfect for textbook learning and exams.
But when I look at the drivers of investor mistakes, it’s not a lack of textbook learning, it’s a lack of mental training. It’s the haphazard nature by which we apply the knowledge we have.
It’s important to understand the distinction between traditional finance theory and investor reality.
Most investors learn a typical traditional finance curriculum. We are taught that all investors are rational, we should focus on the efficient frontier, it assumes minimal or no costs, and it prioritizes a mathematical/quantitative approach as the key to success. These are left-brained skills that focus on analysis, mathematics, and logic. We’ve uncovered some good insights with this line of research. However, it’s too incomplete to be useful. It’s necessary but not sufficient.
Traditional finance theory completely ignores the human element.
Reality as I see it, and how most of you will see it, is that the real world is much different. We have bounded rationality, meaning we act rationally in some areas, but in other areas we act in suboptimal ways. Investing is one of those big areas. We are human and are emotionally driven. We get excited and greedy when markets are up and depressed and fearful when markets are down. Rarely do we exhibit this nice, normal, baseline behavior throughout market ups and downs. We know market timing, trading costs, and taxes are real and have a significant effect on total returns. We need a lot more than the quantitative, traditional finance approach – psychology is the key to success.
We need to study how investors actually behave, not how theory tells us they should behave. Some financial theories have become so removed from reality it’s actually damaging. It’s taken the focus that should be on the human, and it’s placed it entirely on the computational and mathematical side.
So why is investor reality so different than what traditional finance theory tells us?
The biggest reason is we operate in a VUCA environment.
VUCA stands for Volatility, Uncertainty, Complexity, and Ambiguity. This term originated in the military and described the rapidly changing environments of modern warfare after the cold war.
Incidentally, it perfectly describes the nature of investment markets. We don’t invest in a static, predictable world. Our issue though is not a lack of intelligence. It’s not a lack of information. We live in a world with more information and more access to knowledge than ever before. It’s making sure we apply the knowledge we have consistently and correctly.
There is a big reason we struggle in these environments. We simply don’t train under VUCA scenarios. We’re much more comfortable studying facts and formulas than building our resilience to these environments. As is often said in the military - You don’t rise to the occasion, you fall to the level of your training. If you don’t train for these environments, don’t expect to create new abilities that suddenly make you capable of making decisions you’ve never rehearsed before.
The best way to build your resilience is to learn the lessons, habits, and rituals of other elite, high-stress performers.
It’s this simple idea that other experts have already figured out optimal ways of performance. We should learn to model our own behavior based on their insights.
We need to examine how elite performers train and excel under pressure environments - Navy Seals, pilots, surgeons, astronauts, etc. We’re trying to answer the same question – how do we focus your mind, control your stress, and excel under pressure? We’re going to take the best of what other people have figured out and use it for ourselves. These are not theories. It’s actual training methodologies used by world-class performers.
Charlie Munger, the business partner of Warrant Buffett, says it best:
“I believe in the discipline of mastering the best that other people have ever figured out. I don't believe in just sitting down and trying to dream it all up yourself. Nobody's that smart.”
We don’t have to do this ourselves, so we’re going to lean on other experts to help us. Future articles will describe in detail how we can use other experts to improve our investing ability.