When it comes to investing, the adage that temperament trumps raw intelligence is most definitely true. Behavioral economics dispels the dated notion that all investors are cold, logical, rational actors seeking to maximize investment gains. In theory, we might all believe we are cold, logical, rational actors seeking to maximize investment gains. But in reality, theory – especially those surrounding the social sciences – often does not play out so neatly. I first began learning about finance 4 years ago. That continues to this day and will likely never stop. I first started actively acquiring fractional shares of attractive businesses 2 years ago, with the process accelerating a year ago as the student loans got paid off. Here are some thoughts on temperament I’ve gleaned over the years.
I don’t mean to be rude, but if you do not have the correct temperament, you should not be investing in stocks. Really. Why? If you don’t have the temperament to be able to handle the volatility that comes with stock ownership, you will cause yourself real financial harm. You might be prone to herd mentality and follow into ridiculously over-priced stocks, like during the run up of the internet stock bubble in the 1990s. Or you might panic during a crash like during the financial crisis in 2007-2008 and sell out at huge losses because you can’t stand the extreme volatility.What is the correct temperament for investing? The ability to remain cold, logical, rational, with little to no emotion involved. Basically the complete opposite of being a human being. Not many people can operate like this. Why? Because we are human beings, driven by emotion.
When it comes to raw intelligence, I would place myself right around average. I’m no genius. I have friends who can run circles around me with the amount of raw IQ they possess.
What I lack in raw IQ, I make up for in other areas. I am intensely curious. My mother used to tell me that as a small child, I would incessantly ask her questions to the point of annoyance. When I find things that interest me, I just want to know. And I’ll dig and dig and dig to satiate that curiosity.
Along with a strong sense of curiosity, my greatest strength is my intrapersonal intelligence. I know what I know and what I don’t know. One of my most often used phrases when I’m asked a question is “I don’t know” because I’m not going to give some BS answer to something I don’t know anything about. When it comes to investing, it is so very important to distinguish what you know and what you don’t know.
Built on this introspection, I know that I can readily turn my emotions off. I don’t know if it’s a skill or a curse. But from everything I’ve learned about what the most successful investors say is the most important trait to possess, it seemed like it was more of a benefit than not.
So in theory, before I actually started investing, I knew I possessed enough intelligence, curiosity, and unemotional temperament. In theory.
There are certain things that cannot be adequately explained to a virgin either by words or pictures.
You can learn the knowledge and theory all you want, but you need to test in the real world to see how it all holds up.
After experiencing the process of investing for the past 2 years, I can fully appreciate why the average investor has only made 2.6% in the past 10 years when the index alone has returned 7.4%: emotion. Temperament is all important to avoiding buying high and selling low.
Buying high and selling low. Reading this, you might wonder why anyone would fall into the trap of buying high and selling low. Behavioral economics, especially the work by Daniel Kahneman in his book Thinking Fast and Slow, explains that people process wins and losses much differently than you might think.
For example, if you have a $10 gain, you will feel happy. But if you are subjected to a $10 loss, the pain from that loss is exponentially greater than whatever happiness you felt from the gain. Losses are more painful than gains and people tend to try and avoid pain as much as possible.
Even though I understood myself and all these concepts, I would be lying if I said I didn’t experience the gauntlet of emotions you go through when you’re in the market. It feels great when you see your holdings rise in value (albeit offset a little by the annoyance that it’s gotten more expensive to buy more shares). It feels kind of bad when you see it drop in value (but offset by excitement at lower prices to buy).
The ups and downs don’t really bother me that much at all. When I saw some of the holdings fall 30% or more over the summer with the collapse of oil prices and the slowdown in China, I didn’t feel disappointed or pain. In fact, I was more annoyed than anything because I didn’t have enough cash to buy more.
The most dangerous element I’ve encountered is what I call “the itch.” You see the value of a holdings rise and you feel the itch to maybe cash in on the gain. You see the value of a holding fall and you feel the itch to either immediately buy more.
There is this constant, incessant itch to be doing something when really you shouldn’t be doing anything at all.
The only way I’ve been able to combat and relieve the itch is to limit time looking at the portfolio. Looking at the ticker, portfolio, or market news too much has a strange ability to make you itchy. It’s best not to scratch the itch if you have a plan in place.
The itch arises from emotion. You have to be able to recognize that emotion is creeping into your decision making. You need to be introspective and intrapersonally intelligent to spot this. Less you end up like the average investor making pitiful returns by trading too frequently based on emotion.
My investing process is to find great companies, buy shares when the prices become attractive, and hold as long as the economic engine is intact and doing its thing. I have very little interest in trading. I want to amass a collection of great companies bought at fair prices. The idea is simple. That’s the process that makes the most sense to me.
The stock market is a real time, second-by-second, auction system. Millions of people are placing values on companies at all times. It is bound to be volatile because human beings operate the system. And human beings are highly emotional beings. The volatility in the markets is a reflection of our collective emotions.
You can learn theory all you want, but like any science experiment, you need to experiment in reality to see if your ideas hold up.
The most important thing I’ve learned is the importance of temperament and investing: it is 100%, absolutely true that you need the correct temperament to be successful in the markets.