How to Handle Market Uncertainty - Why Emotional Stability Beats IQ

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.


The Resilient Investor: 10 Habits of Mentally Tough Investors

Great investors develop mental toughness through proper mindset and habits. These are 10 guiding principles to condition the mind for investment success. 

1. They Don’t Worry About Issues Outside Their Control 

Much of investing and life is outside your control. Wise investors learn to recognize what they can control and what they can’t. The things that can’t be controlled are ignored. 

2. They Don’t Obsess Over Volatility

It’s a fact: every day markets go up and down. Trying to obsessively negate volatility usually worsens it. The value of every asset you own, including your own human capital, moves up and down every day. Only you don’t see it, so you normally don’t worry about it. Do the same for random market fluctuations. 

3. They Don’t Judge Success by Short-Term Results

Great things take time – going through medical school, becoming a professional athlete, or mastering chess. Investing is no different. The quick wins in investing are usually random and short-lived. Luck rules in the short term, process rules in the long term.

4. They Don’t Blindly Follow Popular Wisdom

Great ideas develop from an independent and thoughtful analysis – and may or may not conform to the crowd. While the crowd is often right, it spectacularly fails when you need it the most. The crowd is not the judge of a good vs. bad decision. Facts and reason are the judge.

5. They Don’t Abandon Their Strategy

All strategies temporarily fail at some time. Even the winningest coaches and athletes have losing seasons and rough periods. Thoughtful investing plans go through the same ups and downs. Investors constantly chase what is working today, only to get in at the peak and bail at the bottom.

6. They Don’t Feel the Market Owes Them Anything

Whatever insight or idea you believe is the next big thing is not as good as you think it is. At best it’s probably mediocre and at worst it’s a disaster. The market does not exist to guarantee a happy retirement. It doesn’t always work out. It doesn’t care how hard you work. Investing success is dependent on accepting that you are entirely responsible for your success or failure.

7. They Don’t Compare Results to Other Investors

There will always be investors richer than you so get over it. When most investors talk about their big winners they are either lying or selectively forgetting about all losers they’ve had. Comparisons to others only inflame ego and emotionally destructive decisions.

8. They Don’t Have Absolute Confidence

Great investors have an understated confidence: confident in their long-term process, humble in their short-term forecasts and market predictions.

9. They Don’t Stress Over Continuously Changing Conditions

As the saying goes, the only constant is change. Great investors embrace unpredictability, amateur investors are paralyzed by it. Success comes not from anticipating change, but adapting to change.

10. They Don’t Live in the Past

Of course the past is obvious in hindsight. Great investors accept their mistakes, omissions, and failures. The past is a sunk cost. All that matters is you learn from the past and then move forward. Focus on today and your plan going forward.

The Resilient Investor: Harnessing Investor Psychology in a Volatile and Unpredictable World

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.