Adam Grossman, founder of asset manager Mayport, recently gave an overview of the four main factors that can combine to cause catastrophic investment results.
Success does not depend on a high IQ, according to him. He quotes Warren Buffett as saying, “Investing is not a game where someone with an IQ of 160 beats someone with an IQ of 130.”
But what is it about? Grossman has singled out four factors.
Grossman: “Having good information is important, but which knowledge is most useful? Two types of knowledge stand out. First, it is knowledge of historical data. The standard investment disclaimer states that past performance is no guarantee for the future. That is undoubtedly true. Yet the past is the best starting point we have. It is especially important to study past periods of boom and bust.
Historically, the US stock market has delivered an average annual return of about 10%. That sounds like a nice round number, and it is. The problem is that that 10% comes with a lot of ups and downs. There have been periods when the market lost 50% and it took years to get back to the old level. Therefore, it is invaluable to know about past recessions, including their frequency, depth and duration.
It is also wise for an investor to take in a good portion of theory, including the principles of stock valuation. What is the meaning of a price-earnings ratio (P/E) and what is a normal P/E for different types of stocks?
These simple measures, combined with a knowledge of history, can prove invaluable if the market finds itself in one of its regular tulip bulb crazes.”
Grossman: “There are limits to what a person can learn from textbooks. That is why experience is crucial. What I’ve noticed over the years is that stock market bubbles are rare. It doesn’t happen every year, not even every five years. It is on average closer to once every twenty years. How did that happen? I think it has to do with investor memory.
With each boom-and-bust cycle, a young generation of investors sees firsthand what a stock market mania looks like and how it ends. They take those lessons into account in their future actions. But over time comes a generation too young to remember the pain of previous cycles. Then it’s their turn to learn painful lessons.
In my columns I often refer to my 25-year-old cousin. Since he started high school, he has experienced a stock market that has risen almost incessantly. It’s no wonder, then, that he joined the Robinhood stock craze last year by speculating with options. In the past six months, he has seen how something like this can turn out. I suspect investors of his generation will be more cautious going forward.
But it is not necessarily necessary to make sense through trial and error. You can also learn from investors who have already been through a lot. One of the most famous is, of course, Warren Buffett. Anyone who has attended their annual shareholders’ meeting knows that they often think in historical terms.
Another investor worth following in this regard is Howard Marks, a fund manager who started his career in the 1960s during the Nifty Fifty boom. That was in many ways a precursor to the dotcom bubble of the 1990s. Marks has been writing memos for his clients for years. They are all available on his AT&T companies’ websites, for example here . Together they make up one of the best courses available in stock market history.”
Grossman: “Modern Portfolio Theory (MPT) is a concept that has long dominated investment theory. It is a mathematical approach to how a portfolio should be built.
But in the late 1970s, two psychologists, Amos Tversky and Daniel Kahneman, came up with a new way of thinking that rocked the MPT. ‘Mathematics is important’, they said, ‘but psychology certainly is too’.
Here, too, Buffett is a textbook example. In his public appearances, he talks a lot about psychology and decision-making, much more than raw numbers. What always comes back to him is an important basic message: Be sensible.
I know, that’s easier said than done. Therefore, I recommend learning more about the behavioral patterns that Tversky, Kahneman, and others have discovered. In particular, it is useful to learn about the “prospect theory” or the so-called ” recency bias ” (recent events are valued more than older ones) and the anchoring effect or reference effect.”
Luck (and Bad Luck)
Grossman: “The last factor is luck. At first glance this may seem a strange choice. After all, you cannot force happiness. Still, I see it as an important factor on the road to success.
Luck cannot be predicted, but there are ways to make better use of it by designing your strategy in such a way that you as an investor are prepared when luck or bad luck comes your way.
For example, the category of luck includes an unexpected promotion or windfall. For example, consider the high oil price. It is good to have a plan for these kinds of “ windfall ” situations. For example, it may be a good time to pay off part of the mortgage. The danger of not having a plan is that luck has a habit of turning into bad luck.
For bad luck situations, having a plan is even more important if possible. Make sure you have a plan B and maybe even a plan C in case things go wrong. That may seem depressing, but there are a lot of people who afterwards were happy that they had such a plan.”
High IQ no guarantee
Back to intelligence for a moment: Why is that less important in Buffett’s eyes? “Maybe because it’s a double-edged blade,” Grossman says.
“On the one hand, there is the so-called Dunning-Kruger effect. This describes people who do not have a high IQ, but who still suffer from overconfidence because they cannot properly assess their own abilities.
On the other hand, genius is also no guarantee of success. The most famous example in recent stock market history is probably the hedge fund Long Term Capital Management (LTCM). The fund went down spectacularly, despite the fact that two Nobel laureates were among its founders.
Overconfidence can be an even deeper pitfall for people who think they are brilliant than for people who are less intelligent.”