Mental Model: Temperament

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.

In Theory

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.

In Reality

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 Itch

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.

Conclusion

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.

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10 thoughts on “Mental Model: Temperament

  1. This is great. The first part sounds a lot like me. The itch is real. I think the best counter can be keeping a good list of companies you’ve checked and valued and simply holding true until you see the price. Sometimes the itch will cause you to pull the trigger too early on things. I’ve done it. That’s what learning is all about. But your return is built on the purchase price so caving early can be detrimental. But it still happens!

    1. The dilemma is though, *if* you find an amazing business with competitive advantages that will compound for decades on end at “satisfactory rates” (say a Coca Cola all throughout the 20th century), and *if* your holding period is “forever”, it won’t matter at all if you bought at the all time high price or you bought at a bargain at the all time low price.

      The way compounding works, the initial discount won’t matter at all given enough decades to compound. The compounding effect is exponentially more powerful given enough time than any discount you could have gotten.

      So in a real life example in the moment right now, Brown-Forman is an excellent, excellent business. However, it is priced at +30 P/E because of its excellence (and perhaps some over-excitement). There have been periods where you could have bought Brown-Forman for way under +30 P/E. Given the excellence of the business, *if* it continues chugging along and doing its thing with its economic engine and competitive advantages intact for the next several decades, it won’t have mattered if you paid +30 P/E or under 30 P/E – your results given enough time will be reflected by the compounding, not the initial discount you got on the stock.

      But that’s *if*.

      1. Not sure about compounding overwhelming the discounted price and making it irrelevant. Lets say I buy $10,000 of stock worth $28. The next day it goes to $32 and you buy $10,000 worth and then it compounds at 10% for 40 years. I end up with $517k and you have $452k, that’s a big difference in my book all because my timing was a little better.

        1. Apologies, I should clarify what I meant: you are completely right that the initial discount you could get to intrinsic value will lead to being able to purchase more shares, which will – like in your demonstration above – lead to higher returns.

          A high return on equity is going to generate exponential results over time due to the nature of compounding while the price you pay is only going to affect the results linearly. The ROE/ROC/ROA will drive the growth in the value of equity in a business. The margin of safety of a stock is a one-off discount, but in the long run, ROE/ROC/ROA drives your returns.

          I should have been more clear about what I meant above: I was trying to get across the importance of exponential returns via compounding as more meaningful than the linear effect of getting a one off discount. I shouldn’t have used such strong language like “the initial discount won’t matter at all” – that was erroneous of me as I was just trying to emphasis the importance of exponential vs. linear growth.

          However, the one off discount will matter and have an impact *if* the business is a wonderful business with sustainable high ROE/ROC/ROA. Sorry for butchering the above post and causing confusion!

          1. Which is a reason why a company like Colgate or Hershey will no doubt outperform a company like Ford over the next 30 years if all things stay equal. You could likely do well playing the cycle on a stock like Ford, but for sheer buy-and-hold, a company like Hershey will annihilate.

  2. “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.”

    Hmmm, dunno about that. From your writing, I’ve always thought that you were one of the exceptional ones. Anyway, it’s always better to underestimate your abilities than to overestimate.

    All of this reminded me of a Munger quote that I read earlier this morning in the throne room:
    “I would argue that what Berkshire has done has mostly been using trivial knowledge…if you absorb the important basic knowledge…and you absorb all the big basic points across a broad range of disciplines, one day you’ll walk down the street and you’ll find that you’re one of the very most competent members of your generation, and that many people who were quicker mentally and worked harder are in your dust.”

    I’ve often had similar thoughts. I have an acquaintance who is a nuclear physicist that studies plasma containers for fusion. He is a genius, much smarter than I. Financially though, I’m so far ahead that he’ll never catch up. You don’t have to be a genius to get rich investing.

    1. He he, I see a lot of people (both online and in real life) that pump out raw IQ beyond my own capabilities – it’s probably better to underestimate than overestimate. I don’t want to be getting all cocky a la LTCM 😉

      I mean I do sometimes wonder and question whether I even know what I’m doing. Sometimes I feel like saying “ef this just buy the index fund”, but then I start wondering and questioning if I even understand what the index funds are and if I truly understand the risks associated with them. I’m confidently unsure most of the time.

      Munger has been one of the pillars of my education, along with a select few others. And I must thank you for the constant recommendations early on. I’m sure I would have eventually gotten around to reading his work, but you expedited the process!

      And yes, I also know of very, very intelligent people who are not able to handle the volatility associated with the markets.

  3. Actually, DALBAR has an incentive to create apples to oranges comparisons, in order to sell its reports to financial advisers, who need “proof” that investors are dumb, and therefore sell them their “services”

    The lesson to learn is that you should be extremely skeptical about everyone that presents you with data or opinions. Data could be manipulated in a way that supports a conclusion from the very beginning.

    1. Agreed that one should always be skeptical of where data is coming from.

      I think its all about the way one approaches the data that’s handed to you. When I read that report, what I see is that human beings are very prone to making irrational decisions when faced with greed and volatility. I then ask, how do I protect myself from that outcome? What processes and systems do I need in place in my life to limit that risk as much as possible? Do I possess enough intelligence? Do I possess enough reptilian like emotions when dealing with business ownership? Think, reflect, and move forward.

      I guess what I got out of it was not so much whether the data was “pure” but rather what lessons I could learn from what the data says. Because no matter how skeptical we may want to be of this one data set, I don’t think what it is stating in general is a false conclusion – that investors routinely succumb to irrationality in the face of greed.

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