After I published a post showing that there is no connection between intelligence and performance amongst fund managers, I had a lot of conversations about it with readers. The general tone of the conversations was that everybody agrees that high IQ investors don’t necessarily have better performance, but many people seem to wonder what differentiates great investors from everybody else.
Of course, books have been written about that and many more will be written in the future. It’s a topic that has no clear answer, but a great chat with Preston McSwain (whose blog you should definitely read) gave me some inspiration.
We both agreed that being overly analytic or model-driven is probably a danger in itself. The examples of the CDO bust in 2008, LTCM in 1998, and CPPI in 1987 along with many more show that complex models work – until they don’t.
Yet, numbers give you a sense of security. And especially inexperienced investors crave that kind of security and clarity. A study by Eleonore Batteux and her colleagues from UCL showed that inexperienced investors would invest more when provided with point estimates for future returns rather than a range of returns. And the wider the range of possible outcomes the lower the investments.
The impact of forecast ranges on investments
Source: Batteux et al. (2020).
Models provide deceitful precision even if in the real world, there is no such thing. The result is that the precision of models tempts us to become overconfident in our abilities and take on too much risk. Inexperienced investors become overconfident if you show them a point forecast for future growth instead of a range of outcomes. For experienced investors, you need Nobel Prize winners and their theories, but the result is the same.
On the other hand, you have intuitive investors who have one great idea that works and then think they are geniuses. John Paulson who made billions in the financial crisis but has since lost money for his investors left and right is probably one of these investors (though he would likely claim that he is very analytical).
What differentiates great investors is their ability to strike a healthy balance between the two extremes? Great investors are highly analytical and can understand complex models. But they also recognise situations when the models no longer apply. Warren Buffet and Charlie Munger foster their image of simple men in public, but they are experts in using warrants and other derivatives to their advantage. Yet, in extreme situations like the financial crisis, they know that models no longer work, and they have to trust their gut instinct, intuition, or plain common sense. That’s why they were willing to invest in US banks at the height of the financial crisis when most investors thought one after the other would go bankrupt.
And then, I think, there is a third ingredient: Knowing yourself.
Knowing what your personal strengths and weaknesses are is key to investment success. So many investors try to emulate Buffet or any other investment legend and copy their techniques. But that rarely works because we all are different. I don’t have the patience that many great investors have. So, I had to devise techniques that fit my personality. They work for me and provide me with an edge in markets, yet I won’t recommend to anyone to do as I do.
Rather do as I say: Find your own way. Study not only the markets but yourself. Learn to build models and then learn when to ignore them. Get a feeling for the market and then check if the data agrees with you. Over time, that should turn you into a better investor.