- Intelligence and hard work can be bad for investors; what we need instead is resilience.
- Not all of us have the qualities required to be good stock pickers, but we can prevent ourselves suffering because of this lack.
What qualities do we need to be good investors? We can, beyond a certain level, discount intelligence. “To be a great investor you don’t have to have a terrific IQ” Warren Buffett has said. “What you do need is the right temperament.” In fact, intellect can be a liability as it can generate an overconfidence about our ability to pick stocks and funds and hence cause us to trade too much, buy high-charging funds or over invest in risky assets.
Instead, recent research shows that investors need something else – grit, or the ability to keep going during bad times. The University of Kansas’s William Bazley and colleagues have found that resilient people make more money on stock markets than others, even controlling for such determinants of returns as age, education and financial literacy.
There’s a simple reason for this, says Professor Bazley. Grittier people are better able to cope psychologically with losses. This means they are quick to sell losing stocks while less resilient investors cling onto them in the hope of breaking even. And in cutting their losses, gritty investors cut their exposure to the negative momentum effect, whereby losing stocks tend to carry on losing. In doing so, they make more money than more fragile investors.
Here, however, we must make an important distinction, between grit and conscientiousness. The conscientious person is diligent and hard-working but not necessarily resilient to bad times or disruption. Which matters, because Robert Durand at Curtin University in Western Australia has shown that conscientious investors actually perform worse than others. One reason for this is that their belief in the value of hard work causes them to trade too much. Also, they tend to hate admitting failure even to only themselves and so are loath to sell losing stocks, thus putting themselves on the wrong side of momentum.
Conscientious investors suffer another problem, described by Chris Brooks and Louis Williams at the University of Reading. They are less able than others to cope with risk, as they overthink what are random moves and regard them not as mere bad luck but as personal failings. This tempts them to sell at the bottom of the market.
Of course, this is not to say that conscientiousness is always a bad thing. Far from it. Guido Heineck at the University of Erlangen-Nuremberg has shown statistically what you probably already know – that conscientious people earn more than others. This is true even controlling for intelligence and education. Conscientiousness might make you a worse investor, but it increases your chances of making enough money to become an investor in the first place. What is a virtue or not depends upon context: in some contexts, conscientiousness is a good thing, and in other contexts not.
All this means we must heed the ancient Greek advice: “know thyself”. We must ask: do I have the aptitude to be a good investor?
And don’t feel bad if the answer is no. A good investor is not necessarily a good person. Conscientiousness is not the only thing that’s a virtue outside of investing but a menace within. Another of the “big five” personality traits is also a handicap for investors – agreeableness, or being sympathetic and cooperative. This can lose you money by making you more likely to follow the herd. That’s OK if it makes you a momentum investor, but a disaster if it causes you to buy near the top without an exit strategy. The trouble with being agreeable is that you can agree with the wrong people.
If you think you lack the right attributes, the solution is not to give up investing. There is, after all, an equity premium to be picked up – albeit of uncertain magnitude.
Instead, the answer is to learn from another ancient Greek, Odysseus, who tied himself to the mast of his ship to prevent himself from being lured by the Sirens into steering onto the rocks.
Self-restraint works. One reason why your correspondent only holds tracker funds is that he’s too neurotic and too prone to cognitive biases to be a decent stock-picker. Holding trackers, though, isn’t the only commitment device available we can use. Regular monthly investments by direct debit can enforce the habit of regular saving. A commitment to only reviewing your portfolio occasionally can save us from the temptation to trade too much. Or failing that, we can rigorously stick to stop-loss rules: we know that, over the long-term, “sell when prices fall below their 200-day average” works, but it is only one such type of rule.
Maynard Keynes wrote that he was tempted to think that share purchases should be “permanent and indissoluble, like marriage, except by reason of death or other grave cause” and that share dealing should be “inaccessible and expensive.” Most of us would resile from the illiberality of such proposals. But they speak to a genuine problem – that some of us lack the qualities needed to invest successfully, and so must seek protection from our own weaknesses.