Investors Need Strong Stomachs … Not Big Brains

It’s great fun to read heroic investment stories about individuals who made fortunes as a result of exceptional insights or sheer genius.

No one is better at telling these than Michael Lewis, the bestselling author who devotes much of his book, The Big Short, to Steve Eisman, a brilliant and eccentric hedge fund manager who made hundreds of millions in the recent financial crisis by buying credit default swaps on the triple-B-rated tranches (slices) of subprime mortgage bonds.

This is entertaining reading. But it won’t do much — if anything — to enhance your own investment prowess. Trades like these are complicated … and risky. A lot of investors don’t realize, for instance, that when you sell short mortgage bonds you have to cover the interest payments on them until you close out your position.

Sure, these jerry-rigged investments were bound to tank eventually. But as John Maynard Keynes once observed, “The market can stay irrational longer than you can stay solvent.” And that’s especially true when you’re all leveraged up.

A lesson from Warren Buffett

Fortunately, you don’t need to take huge risks or boast a Mensa-like IQ to succeed at investing. All you need is a sensible, battle-tested investment system and the emotional fortitude to see it through. Just ask Warren Buffett.

At the Berkshire Hathaway shareholders’ meeting two years ago, he told the audience:

“If you are in the investment business and have an IQ of 150, sell 30 points to someone else. What you need instead is an emotional stability and inner peace about your decisions.”

How right he is. I know, because over a 16-year period, I worked with several hundred high-net-worth investors. The vast majority of these folks were plenty smart. After all, the affluent are usually either professionals (like doctors or lawyers) or business owners. You don’t find a lot of dummies in these categories.

Yet many stumbled as investors anyway. Why? Often it was because they didn’t have the calmness — what Buffett calls “emotional stability” — to stick with an investment discipline when the financial markets got rough and the news backdrop got scary.

It astonished me, for instance, that the very same people who regretted how they panicked after the market crash of 1987, bailed out after every dip and sell-off in the years that followed. Each time their emotional response — fear of loss — trumped their logical decision-making.

Ironically, on the initial client interview — where we talked about the likelihood of market volatility and the value of sticking with a discipline — these same folks were confident that they would use a future downturn as a buying opportunity. But when the merchandise actually went on sale, only one in 10 would step up to buy the bargains. Later, when the market was much higher and the danger had passed, they felt comfortable enough to put money to work again. (As Kurt Vonnegut would say: “And so it goes.”)

How to Avoid Following the Herd

How can you avoid this fate? With four steps:

• Number one, it’s your money. You should understand the basic fundamentals of investing. Many people lose confidence and panic because they simply don’t know what they’re doing.

• Two, expect the unexpected. Look back at the history of the market. Waiting behind every bull market is a bear market. And behind every bear market is yet another bull market. That’s just the nature of things. So don’t be surprised when it happens.

• Three, take the long view. If you’re investing your long-term-growth capital for use in 2020, for instance, is it really important what the market does this week, this month or even this year?

• Lastly, understand that we are hardwired to react emotionally. When our ancestors on the plains of Africa heard a rustling in the bushes, they fled (even if it was just the wind). Those who shrugged it off and kept whistling didn’t leave as many descendants. But a fear response in the financial markets is not generally helpful. As investment legend Peter Lynch used to say, “If you’re going to panic, do it early.”

In short, the best rewards don’t generally accrue to the investors with the biggest brains. (Just ask the Nobel laureates who brought down long-term capital management.) Rather, they go to those with the strongest stomachs.

That’s a good thing to remember, especially when the markets are acting skittish, as they have recently.