What gives these investing superstar investors their edge?
What do Buffett, Soros, Lynch, and Dalio have in common? All are great investors, even though their strategies differ. What they share the ability to control emotions and make clear, probability-based investment decisions. They know how to use critical thinking skills.
The psychology of investing is the biggest challenge for most investors. Getting a handle on how you think, react, and make decisions is a key part of investing skill. Humans will never stop making emotional mistakes. Focusing some of your time and energy on figuring out why you make those mistakes will make you a much better investor.
Michael Mauboussin explains probability-weighted decisions this way: “Expected value is the weighted-average value for a distribution of possible outcomes. You calculate it by multiplying the payoff (the potential gain) for a given outcome by the probability that the outcome materializes.”
If you can think probabilistically while controlling your emotions, investing starts to get easier. But most amateur investors think about what’s possible, rather than what’s probable. This is a big mistake because it leads to making too many long-shot bets that never pay off. Statistically it’s better to hit singles and doubles than to swing for the fences and strike out 4 out of 5 times.
Managing your investments can be both overwhelming and boring
There are two primary reasons why so many people don’t live up to their potential as investors. The first is that they become overwhelmed by the complexity of the decision making process. And secondly, many don’t care about investing because they find it tedious and boring.
If you don’t find the challenge of navigating the complexities of managing your investments interesting you should not be trying to outperform the markets. Most part time investors would get better results by buying and holding a diversified portfolio of low fee index tracking funds.
The problem with investment advice as a profession is that it’s also a business
All else equal, a talented sales staff will trump a talented investment staff when attracting assets and opening accounts. There are organizations that can have both, but typically the firms with the best sales teams will end up bringing in the most money from investors. A well-thought-out narrative by an intelligent, experienced marketing department can do wonders at persuading investors to hand over their money. It’s difficult to admit we can be so easily persuaded but it’s true.
Most investments are sold rather than purchased. Nothing else explains people still paying sales loads when purchasing an investment, when they are often easily avoided. There are people who can sell ice to Eskimos and many of them are selling investments.
Pay attention to incentive-based conflicts of interest
There are conflicts of interest everywhere in the financial services industry. It is a business after all. The key is to understand how incentives drive people’s actions and look for those incentives behind everything you see, hear, and read. Everyone is talking their book, all the time.
Daniel Kahneman puts it this way: “Facts that threaten people’s livelihood and self-esteem — are simply not absorbed. The mind does not digest them.” Warren Buffett advises people to beware of asking your barber if you need a haircut for that reason.
Buffett’s partner Charlie Munger said recently: “If the incentives are wrong, the behavior will be wrong. I guarantee it.” That reinforces what he said many years earlier: “I understand the power of incentives, and yet I’ve always underestimated it. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.”
Don’t confuse brains with a bull market
It’s easy to be a long-term investor during a bull market. Everyone’s making money and it feels like you can do no wrong. It’s when things start to go sideways that this group loses control.
People panic. Not only do they panic, but they follow other people who have panicked, who are in turn following other people who have panicked. Being part of the herd is most often not a good thing. To outperform the herd you must leave the comfort of the herd and be right about your reason for leaving.
Going against the herd (being a contrarian as an investor) can be very difficult. Contrarians must inevitably go through periods of under-performance and sometimes even ridicule from the herd. And being too early is often indistinguishable from being wrong.
Successful investing, Mr. Munger once said, requires “this crazy combination of gumption and patience, and then being ready to pounce when the opportunity presents itself, because in this world opportunities just don’t last very long.” Sitting on the sidelines in a rising market with cash earning just about nothing is a very hard thing to do.
Know thyself
Understanding how you think and make decisions, and your own tendencies towards bias and self-delusion, can be much more valuable than knowing exactly what’s going on in the markets. You have no control over what’s going to happen in the markets, but you at least have some control over your reactions to what happens.
Most mistakes are psychological or emotional. Even Daniel Kahneman has said that after a lifetime of study of dysfunctional heuristics he still makes bonehead errors. Staying rational when making investment decisions is a life long struggle. You can never learn enough so that dysfunctional heuristics won’t potentially lead you to folly and error.
Everyone makes mistakes. The job of an investor is to make fewer new mistakes and to try to avoid making epic mistakes. Simply avoiding the trap of idiocy is highly useful. Knowing yourself pays big dividends if you are an investor.
Nothing sells better than certainty, confidence and the allure of something-for-nothing
People like people who are confident. Daniel Kahneman writes: “Overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.”
You’ve seen these supremely confident motivational speakers make their pitch to investors saying things like “Just follow these seven steps and you will be rich.” It’s bullshit, but as long as it is presented confidently, the masses will follow.
Investment sales people know how to manipulate statistics
When someone shows you a spreadsheet and makes an argument based on that spreadsheet, I suggest that you immediately start asking questions about the assumptions. This tactic will save you lots of time and wasted energy. Contrary to that old proverb, the devil is actually making trouble in the assumptions rather than in the details. People who believe that projections that run seven years into the future are accurate are guilty of wishful thinking and extreme gullibility.
Sometimes, knowing what not to do is just as important as figuring out the best way to do something.
Getting ahead by avoiding stupidity, especially if the decision can potentially result in a big loss, is a simple and powerful idea. No one personifies this idea more than Charlie Munger. “I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity.” In learning what not to do, it is best if you learn through other people’s mistakes rather than your own. Avoiding stupidity is best done vicariously. There is no better way to see a lot of stupid behavior over a short time than reading.