By David Van Knapp
You’ve probably heard of Mensa. It is a society that limits its membership to people with IQ’s in the top 2% of the population. Mensa was founded in England in 1946. Nowadays “Mensans” are found all over the world and in all walks of life. The only requirement for membership is an IQ in the 98th percentile or better. Mensa has over 100,00 members, about half of them in the USA.
It turns out that Mensa has an investment club. Wow. That must be one heck of a way to make money, right? The smartest people in the world making investment decisions.
Well, not so fast. During the 15-year period 1986 to 2001, the S&P 500 had average annual returns of 15.3%, but the Mensa investment club’s performance averaged returns of just 2.5%. Let’s see, that would be 84% worse than the index.
How could this be? An amusing article by Eleanor Laise (”If We’re So Smart, Why Aren’t We Rich?”) details the smart-but-undisciplined investment approach that reduced Mensa’s returns to fiasco status. In brief, the investing “strategy” of the club relied on trendy tech stocks, horrible timing, and over-reliance on charting. The “strategy” was constantly changed. Some stock picks were taken straight from Internet message boards. One member described the approach as “buy low, sell lower.”
As Warren Buffett has said, “Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ….What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
Mensa’s performance reminds one of another notorious group of smart people who managed to blow up so badly that their mistakes threatened the world’s economy. That would be hedge fund Long Term Capital Management (LTCM), which melted down in 1998. Founded by experienced economists, traders, and future Nobel prize winners, and aggressively run with the aid of finely tuned computer models, LTCM had to be bailed out by the Fed, which pulled together Wall Street’s leading banks to underwrite the bailout. The LTCM incident is wonderfully documented in Roger Lowenstein’s book, “When Genius Failed.”
Where is a copy of “Sensible Stock Investing” when you need it?
Why did these two groups of brilliant people fail as investors? Put simply, they were overconfident, inconsistent, and blind. All at the same time. In other words, their failures were not caused by lack of conventional IQ-type intelligence. Their failures were caused by lack of investing intelligence.
In 1996, Daniel Goleman wrote “Emotional Intelligence: Why It Can Matter More Than IQ.” It provides a framework for understanding how really smart people can make really dumb decisions. He wrote, “As we all know from experience, when it comes to shaping our decisions and our actions, feeling counts every bit as much-and often more-than thought….Passions overwhelm reason time and again.”
The field of Behavioral Finance lifted off about 30 years ago. It is devoted to finding out how people really act when making financial decisions. Consistent with Goleman’s thesis, Behavioral Finance has found that investors are often influenced by emotion, and that therefore they make illogical, inconsistent, and ill-informed decisions, despite their best intentions to act in their own self-interest.
It turns out that humans, no matter how “smart” we are, are hard-wired with several tendencies that don’t help very much when investing. Our judgment gets skewed. Some of these common traits include:
• Loss aversion: Holding illogically onto a hopeless investment, hoping that it will come back. People do not want to admit having made a mistaken investment. They want to avoid regret over the loss-so they just don’t book it. If they are arrogant enough, they not only refuse to admit the investment is a loser, they double down their bets while the doomed investment is tanking. (That’s what Long Term Capital Management did.)
• Selling winners too soon: Locking in profits to create a feeling of victory. Ta-dah!
• Forgetting that the real goal of investing is not to justify decisions you made that got you to where you are right now. This can lead you to focus on the past rather than evaluate your investments on their future potential. In short, arrogance about your previous decisions convinces you that “the market is wrong” and you will eventually be vindicated.
• “Preferential bias”: Difficulty in changing an opinion once the opinion has been formed. This causes incoming data to be processed selectively, with supportive information favored and contradictory information downplayed or even ignored. The end result is reduced objectivity. (Both LTCM and Mensa probably did this.)
• Constantly changing tactics, following what’s hot (emotionalism), rather than sticking with a sound long-term strategy. (Mensa did this. It adjusted its “strategies” quarterly-meaning that they were not strategies at all, just short-term, flip-flopping approaches.)
The Sensible Stock Investor needs to be as rational as possible, because over time, the stock market tends to reward rational decisions. The market tends to move stocks towards their intrinsic values. For example, if you paid too much for a stock, over time the market will reduce your returns from that stock or even turn them into actual losses as it brings the price of the stock back to what it is really worth. Regretting the loss, failing to accept the sunk cost, holding onto the loser too long, and/or failing to look ahead rather then back obviously do not help you make the best decision in this situation.
Fortunately, we humans can counteract some of our right-brained emotional tendencies by using our left brain to create tools and processes to increase our “investing intelligence.” Such tools and processes include:
A fact-based system for evaluating whether a company is a good company.
Calculating a well reasoned number as a fair price for its stock.
Resolving never to make snap judgments on fragments of information or hot tips.
Writing out your investment goals.
Honestly assessing your appetite for risk.
Designing a strategy that is likely to lead to achieving your goals without making you uncomfortable as to its risk.
Sticking to-perhaps automating-your well-laid investment plans in a disciplined fashion, ignoring short-term “noise” in the market.
Resisting the urge to “do something” all the time.
Reviewing and updating your approach annually as your life situation changes and you learn more about investing.
Systematically reviewing your holdings-that is, performing a reality check-with your eye always on the future.
The studies in Behavioral Finance clearly show that it is not your store of market knowledge nor your traditional IQ that are most likely to determine your success as an investor. It is whether or not you let your emotions dictate your actions. In the end, you want to apply your intelligence and objectivity to overcome self-defeating emotional tendencies in your investing. That will help make you a Sensible Stock Investor, no matter what you may score on standardized IQ tests.
If you would like to learn about a stock investment approach that that uses the common-sense strategies reflected in this article, please consider purchasing “Sensible Stock Investing: How to Pick, Value, and Manage Stocks.” Click on this link to go directly to the book’s page on Amazon.com: http://www.amazon.com/gp/product/059539342X/sr=1-1/qid=1155381420/ref=sr_1_1/002-5852738-5260830?ie=UTF8&s=books . Or click on this link to learn more about the book and its sytematic approach to investing: http://www.SensibleStocks.com
Thank you.
Dave Van Knapp, author, “Sensible Stock Investing.”
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