Author and fund manager Frederik Vanhaverbeke reckons there is one thing that separates top investors from the average investors: investor intelligence. Here he explains how you can learn from the Masters to improve your returns.
What separates top investors from the average Joe: investor intelligence
People with experience in the stock market who are honest with themselves will admit that beating the market is hard. Nevertheless, as I explain in my book Excess Returns: a comparative study of the methods of the world's greatest investors, there are plenty of investors who have proven that it is possible to beat the market consistently over long periods of time.
Figure 1 below illustrates the extent to which a set of top investors has beaten the market over (a large part of) their career. The figure shows their annual outperformance over the S&P 500 index (with dividends reinvested) as a function of the length of their track record. Even sceptics have to admit that beating the market by about 10 per cent a year over half a century, as did Warren Buffett and Shelby Davis, is down to more than mere luck. Likewise, the impressive outperformance of Joel Greenblatt, who managed to turn $1,000 into $840,000 between 1985 and 2005.
Figure 1: Approximate annual outperformance versus the S&P 500 of a set of top investors
What we want to know is how did they do this and what distinguishes these investors from the average investor? My exhaustive study of the methods of these top investors revealed a number of striking similarities in the way they approach the market. They look in the same unconventional places for bargains.Their due diligence focuses on similar elements that most other people tend to overlook. Their risk management flies in the face of conventional wisdom.And they buy and sell in a very disciplined way. But above all, they share a set of uncommon attitudes, mindsets, habits and behaviours that really make a difference in the market place. The latter observation inspired me to focus on the role of "investor intelligence". In the same way that intellectual intelligence and emotional intelligence are measures of a person's intellectual (IQ) and interpersonal capacities and skills (EQ) respectively, investor intelligence is a measure of how a person holds up against the challenges of the market place.
Just as top investors were the pioneers in detecting these cognitive biases decades before academics showed interest, they are the pioneers in coming up with solutions. They actually use a three-pronged defense against cognitive biases: the right attitudes and mindset, stringent process requirements, and some practical habits. Let's take a closer look at some cognitive biases and at the way top investors deal with them.
Some cognitive biases lure investors into unfortunate buy and sell decisions. Typical errors are overtrading (buying and selling too frequently), buying high, selling low, selling winners and hanging on to losers.The strongest bias that is responsible for these errors is probably herding behaviour. It feels safe for investors – especially when they are insecure or uninformed – to buy what others are buying and to sell what others are selling. Irrational trades are also prompted by people's tendency to look for patterns in stock (price) behaviour. In reality, though, most patterns are illusory and caused by random noise. Overconfidence in one's ability to time purchases and sales correctly is yet another reason why so many investors constantly move in and out of stocks. Also the asymmetric loss aversion is responsible for ill-considered trades. As the pain of a loss is twice as intense as the pleasure of a similar gain, investors often sell stocks close to their bottom to make the pain go away. Closely related to this is the overreaction bias, which states that the release of bad news often triggers (exaggerated) panic selling. Conversely, investors sometimes desperately hang on to losing stocks due to mental accounting. They reason that as long as the stock is not sold the loss is not “realised” and one can still nurse the hope of breaking even. Hanging on to losers is often exacerbated by anchoring, which is the tendency to use certain price levels as a reference. Believing that the price at which a stock has been purchased previously is fair or cheap, investors refuse to sell their shares (far) below that purchase price.
Top investors protect themselves against irrational trades through emotional detachment, patience, independence, knowledge, and a focus on the long term. Thanks to hard work they build discretionary and thorough knowledge which enables them to ignore the crowd, and stay in unconventional market positions. They accept with equanimity that they will suffer setbacks and incur temporary losses on their way to riches. And thanks to their patience and their unrelenting focus on the long term, they avoid the pitfall of constantly switching positions in anticipation of short-term market moves, economic market forecasts or political considerations.
Cognitive biases and how top investors deal with them
Top investors pointed out many decades ago that the human brain is not wired correctly to deal with the stock market. Nowadays this is fully acknowledged in the modern academic discipline of Behavioural Finance. Investing appears to be a complex and highly emotional activity that constantly triggers the so-called reflexive system of the human brain. This system prompts investors to take rash and irrational decisions all the time. In fact, it turns out that investors constantly trip up due to a wide range of cognitive biases that spring from one's reflexive system. Many of these cognitive biases are remnants from a distant past when they were crucial for human survival. But they are very harmful in the stock market. Figure 2 gives an overview of the most important cognitive biases and summarises the main investment mistakes they are responsible for.
Figure 2: The main cognitive biases (out rectangle) and the mistake they lead to (inner square)
Top investors also adopt some effective habits to limit the occurrence of cognitive biases. Knowing that price changes trigger many of the cognitive biases discussed above, they try to limit their exposure to price movements. Warren Buffett, for instance, has no Bloomberg terminal on his desk and is not interested in live quotes. The legendary Walter Schloss even didn't have a computer, and monitored his holdings merely through the price quotes in newspapers. Another habit that a top investor such as David Einhorn applies to counter the overreaction bias is to insist on time-out after sudden bad news. He argues that one usually can't think straight when unexpected bad news breaks and that the many other disgruntled investors tend to punish the stock too much. Doing nothing for a few days (or weeks) and reevaluating the company after the dust has settled makes more sense to him.
Another harmful effect of certain cognitive biases is that they make it hard for investors to look objectively at investment ideas. Due to the consistency bias people tend to look for evidence that confirms previous investment decisions and ignore contrary evidence. This will especially be the case for investments that are the result of a lot of effort (ie they have a sunk cost). Other examples are the home bias and the sympathy bias which lead to a positive disposition towards companies that are close to home or that produce products one likes. Even the seasoned investment veteran Kirk Kerkorian lost a bundle when he could not withstand the siren call of GM right before its demise – simply because he had been passionate about cars since boyhood.
An effective way to counter biases that colour the analysis of an investment case is to work hard on getting all the objective facts right, and to be aware of all the pros and cons. Charlie Munger, the sidekick of Buffett, and the successful fund manager Bruce Berkowitz recommend investors to try to kill their best ideas. Peter Cundill regularly appointed someone of his team to play Devil's Advocate to rip his investment ideas apart. And some of the greatest investors regularly talk to professionals who disagree with their point of view (eg short sellers). It stands to reason that these practices will only be effective for investors with a degree of modesty. Only investors who acknowledge their own limitations and fallibility will ask for the opinions of others. And only people who are willing to change their mind based on the input of others will pay attention to the bear case of their thesis.
Because investors tend to fall in love with stocks that served them well, many top stock pickers show tough love towards the winners in their portfolio. John Neff recommends investors sell stocks from the moment you start itching to brag about them. And Michael Steinhardt even sold all of his stocks from time to time to start out with a clean slate devoid of preconceptions.
Apart from the consistency, home and sympathy biases, other cognitive biases can be blamed for poor due diligence. Overconfidence is one. Some investors have so much confidence in their stock picking skills that they skip serious due diligence. Or their due diligence centers around some (possibly irrelevant) recent events (the recency bias) or anecdotes that appeal to the investor (ie framing). The recency bias and framing are at their most destructive when uninformed investors attend meetings with promotional management that stresses the company's positives and stays silent about its negatives. Also the representative bias can render a due diligence worthless, eg when someone believes that a company is extraordinary just because it had two excellent years in a row.
Once again, thorough knowledge acquired through hard and independent work offers a way out. Serious investors guard themselves against shortcuts. They process as much information as possible and look at their investment ideas from all possible angles. And they go well-prepared to meetings with top management. One of Buffett's mentors, the late Philip Fisher, would only meet management or visit a company after an in-depth analysis. In this way, he could be sceptical of what he heard or saw.
Finally, star investor Monish Pabrai has adopted a remarkable practice to make sure that he looks at his investments from all angles. Similar to surgeons before an operation and pilots before take-off, he uses a checklist to make sure that he doesn't overlook anything.
Another problem is that some cognitive biases hamper valuable feedback from previous investment decisions. With hindsight it is often hard to remember the correct context, one's feelings, and the exact information one had at one's disposal at the moment of a previous investment decision. In addition, overconfidence is pervasive among investors. By having too much confidence in their abilities, investors often put the blame on external factors rather than admitting to their personal mistakes.
Finally, most people have no feeling for statistics. Due to the representative bias investors often ascribe something that worked out successfully to their superior process and vice versa – even though the outcome may have had more to do with chance.
Due to poor feedback from past experiences, investors stick with investment approaches that don't work. Even worse, the conviction that one is doing fine in spite of a flawed investment process may embolden investors to leverage their approach. For instance, suppose you make a killing on a penny stock that by some miracle managed to survive a near-certain bankruptcy. You might start to believe that you should put more or all of your money in near-bankrupt penny stocks. Needless to say, this may have devastating consequences further down the road.
Protecting oneself against inadequate feedback starts with a focus on process instead of outcome. Smart investors insist on an investment method that emanates from an effective investment philosophy which explains why stocks can be mispriced. They can clearly say why their method offers an edge in the market. And theyacknowledge its limitations. They do not panic when they temporarily underperform the market because they realise that successful methods do not work all the time (even though they create outperformance over the long term).
Furthermore, a popular practice among top investors to protect themselves against the hindsight bias is to write things down. The famous hedge fund manager Ray Dalio always writes down why he buys or sells a stock at the moment of the trade. This way, he can check later what he was thinking at the moment he initiated the trade. Another habit that some top investors adopt to get valuable feedback is to closely follow the performance of stocks after they are sold. Many people simply move on to other stocks after a sale, and thereby miss useful information about their selling practices.
Other elements of investor intelligence
Modesty (respect versus the market and acceptance of one's own limitations), patience, emotional detachment, knowledge, hard work, independence and a disciplined implementation of an effective investment strategy are recurring themes in the battle against cognitive biases. But they are also indispensable in the wider picture of investing. But besides cognitive biases which have to be kept at bay every step of the way, investors also face other challenges.
Indeed, one has to realise that beating the many smart people in the stock market requires an edge. Intelligent investors try to beat the market through an approach that offers a competitive advantage. In fact, as shown in figure 3 investing with an edge and effectively coping with cognitive biases hinges on three pillars.
Figure 3: The intelligent investor: attitudes, process and method
First there is the investment method. Successful investors buy and sell stocks through a flexible and discretionary method based on a philosophy that explains why certain stocks are mispriced. Top stock pickers select a method that is compatible with their personality and preferences, leveraging their strengths and making their weaknesses irrelevant. Buffett, for instance, steers clear of turnaround stocks and does no short selling. Equally important is that smart investors execute their investment approach consistently – even when it (temporarily) goes against them. To maintain his discipline, Bernard Baruch frequently shook himself loose from Wall Street in the midst of market turmoil to recall all the basic elements that matter in investing.
The second pillar is a rigorous process. To obtain an edge in the market, top investors use a process that is characterised by hard work (eg, going the extra mile to know all the facts), independence (because mimicking others is unlikely to offer an edge), an insistence on thorough knowledge, and discretion. To foster his independence, Peter Cundill didn't want to hear any opinion about a stock before he had finished his own analysis. Another way to maintain independence is to stay far from the scene. Buffett headquartered in Omaha (ie far away from New York). And John Templeton admitted that his performance improved when he moved to Nassau because he was no longer exposed to the same news flow and opinions as the rest of the investment world.
Finally, top investors exhibit high amounts of our critical attitudes: patience, modesty (versus the market), emotional detachment and passion. They realise that they are not in the business of being right but in the business of making money. They are not in a hurry to become wealthy. And many are not in the game for the money, but simply because they are passionate about the game itself.
Note that these three pillars are interrelated. For example, passion is necessary to find the courage to work hard. Knowledge and the application of a method that is compatible with one's personality are instrumental in staying emotionally detached. And knowledge enables investors to remain patient.
According to my study these attitudes, process behaviours and the way one selects and adheres to one's investment method are essential to succeed in the market. It is therefore fair to relate them to the level of investor intelligence. Although many of the aspects of investor intelligence are probably innate, they can be nurtured and cultivated to some extent. Many excellent investors are even convinced that investing is one of the few professions where one becomes more proficient as one grows older. This makes perfect sense. Building true experience takes a long time as market cycles can stretch out over many years or even decades. Coping with cognitive biases is something that investors probably become better at as time goes by. And finding the investment method that suits best with one's personality may require some trial-and-error.
To conclude, let's get some misunderstanding out of the way. A high IQ is definitely not enough to be a successful investor. In fact, it may be an impediment if it is not kept in check by the three pillars, because smart people tend to know better, and often try to complicate things too much. What's more a high IQ offers no protection against cognitive biases. Newton, for instance, lost a fortune in the South Sea Bubble because he blindly followed the crowd. On the other hand, just as a high IQ can help someone with a high EQ to be successful, a high IQ can help someone with a high level of investor intelligence to excel in the market.
