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IQ Isn’t Enough

Adam M. Grossman

A FEW WEEKS BACK, I discussed the notion of “the four horsemen of the investor apocalypse.” A concept proposed by Morningstar Managing Director Don Phillips, these are the factors that—in his experience—tend to lead investors off course. But what about success? What are the factors that contribute to success for investors?

“Investing,” says legendary investor Warren Buffett, “is not a game where the guy with the 160 IQ beats the guy with a 130 IQ… You need to be smart, but not a genius.” In his usual plainspoken way, he adds, “If you have a 150 IQ, sell 30 points to someone else.”

If not intelligence, then what’s most important for investors? “Rationality,” Buffett says, “is essential.” Building on that—and to borrow a phrase from Phillips—here are the four horsemen of success:

1. Knowledge. Information is, of course, useful. But what kind of knowledge is most helpful? Two areas seem important. The first is history. The standard investment disclaimer states that “past performance doesn’t guarantee future results.” That’s undoubtedly true. The future may not look like the past. Nonetheless, it’s the best information we have to go on. In particular, I think it’s important to study past booms and busts.

Historically, the stock market has delivered a 10% average annual return. That sounds like a nice round number, and it is. Trouble is, that 10% comes with a lot of variability. There have been periods when the market has lost 50% and taken years to climb back. That’s why it’s invaluable to have a sense of past downturns, including their frequency, depth and duration.

I would also learn some textbook investment theory, including the principles of investment valuation. What’s the meaning of a price/earnings (P/E) ratio, and what might be a normal P/E range for different types of stocks? These simple metrics, in combination with some knowledge of history, can be invaluable, especially the next time the market goes into one of its regular tulip-like frenzies.

2. Time and experience. There’s only so much anyone can learn from a textbook. That’s why experience is critical.

Something I’ve observed over the years is that stock market bubbles seem to come along only infrequently. They don’t happen every year, or even every five years. It’s more like every 20 years. Why is that? I think it has to do with investors’ memories.

With each boom-and-bust cycle, a new generation of investors sees firsthand what manias look like—and how they end. They then carry those lessons with them. But after some years go by, a new generation comes along—one that was too young to have seen the pain inflicted by the prior cycle. Then it’s their turn to learn these lessons.

I often talk about my nephew, who’s age 25. Until this year, the stock market had been rising, almost without stop, since he was in middle school. It’s no surprise, then, that he participated in the Robinhood meme stock frenzy last year, buying options and other speculative investments. Now, for better or worse, he’s seen how these frenzies turn out. I suspect that investors from his generation will be more cautious going forward.

It’s cold comfort, though, to suggest that investors need to learn the hard way. That’s why I recommend a shortcut. Learn from investors who have lived through major historical events. Among the most thoughtful is, of course, Buffett. If you read his annual letters, he often frames his thinking in historical terms.

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Also worth reading is the work of Howard Marks, an investment manager who started his career in the 1960s, during the Nifty Fifty boom. That was the predecessor to the 1990s dot-com bubble and looked a lot like it. Marks has for years been writing memos to his clients. They’re all available on his firm’s website. Collectively, they represent one of the best courses in market history available anywhere.

3. Mindset. For several decades, beginning in the 1950s, the investment world believed in a concept known as Modern Portfolio Theory. This was a mathematical approach to constructing a portfolio, and it was viewed as the bedrock theory of the investment profession.

But in the late 1970s, two psychologists, Amos Tversky and Daniel Kahneman, upended that thinking with an argument that seemed radical at the time. Math is important, they said, but so is psychology—maybe even more so.

If you listen to Buffett, this comes through clearly. In his public comments, he spends much less time talking about numbers than he does about psychology and decision-making. In fact, most of Buffett’s pithy aphorisms boil down to the same basic message: “Just be sensible.”

This may be easier said than done. That’s why I think it’s worth taking time to learn about the major cognitive biases discovered by Tversky, Kahneman and others. In particular, it’s helpful to know about prospect theoryrecency bias and anchoring.

4. Luck. This last factor—luck—might seem out of place here. After all, there isn’t much we can do to control our luck. But I still see it as one of the four horsemen of success.

While you certainly can’t predict your own luck, there’s something you can do about it: You can structure your plan so you’re well positioned to harness it to your advantage when it does come along. This applies to both good luck and bad.

In the category of good luck, you might receive a promotion or a windfall. These fit in the proverbial “good problem to have” category. Still, it’s helpful to have a plan. You might simply add those dollars to your existing investment strategy. Or you could focus on a specific purpose, such as paying down your mortgage. Whatever you choose, it’s best to be intentional about it. Without a plan, unfortunately, good luck has a habit of turning into bad luck.

Planning for bad luck is of more concern. In general, you want to be prepared for any eventuality—within reason—that might set you back. How can you do this? It’s the flip side of planning for good luck. Have a plan B and maybe a plan C mapped out for a rainy day. That might seem like a depressing exercise, but more than one person has told me that it actually made them feel better, not worse, to think this through.

Back to intelligence: Why, in Buffett’s view, is that less important? It may be because it can cut both ways.

On the one hand, there’s the Dunning-Kruger effect. This describes people who don’t have high IQs but nonetheless suffer from overconfidence because they can’t judge their own abilities. The classic example was McArthur Wheeler, who tried to disguise himself while robbing banks by applying lemon juice to his face. He was quickly caught.

On the other hand, genius hardly guarantees success. The most famous case in the investment world was probably the hedge fund Long-Term Capital Management. It failed spectacularly despite having two Nobel laureates among its founders. The fund’s obituary is a book titled When Genius Failed by Roger Lowenstein. The reality, though, is that this wasn’t the only case in which genius failed. It’s just the most notable. Overconfidence can be a pitfall for those who are highly competent. What’s the antidote? Keep an eye on the four horsemen.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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Nick M
Nick M
3 months ago

Good article as usual, but you mischaracterized the Dunning-Kruger effect. It’s not related to people with low IQ, it’s related to low specific skill, which we all have. For example, a brain surgeon might be fantastic at brain surgery, which leads them to overestimate their own opinion in unrelated fields like rocket science. They are overestimating their ability to sufficiently understand physics, simply because they sufficiently understand biology. It is this overestimating of ability, for any number of reasons, that is the Dunning-Kruger effect.

macropundit
macropundit
3 months ago

Great piece. And great you practiced what you preached about history by mentioning Modern Portfolio Theory. I grew up watching Louis Rukeyser’s Wall Street Week on PBS with my dad. One time someone was pitching me to go from DIY to their managed portfolios and told me how if I diversified it would increase my returns. At the time I didn’t reveal my shock at the suggestion that diversifying could increase returns, but I started to investigate how someone could say that by looking up the phrase he mentioned: “efficient frontiers”. That’s how I came to learn about MPT.

It’s a brilliant theory, but it’s never been clear how and under what conditions it might map onto the real world. I think it has valid application to institutional investing, but little if any for individual investors. But just knowing how the theory came to be imbibed by the financial advisor industrial complex that sallied forth from grad school explained a lot for me. The cynical view is they don’t care about theory except as they can mine it for their own self-interest. I’ve found that many financial types, most I’d say, have never heard of MPT. They know it like a fish knows water, which is to say not at all. For the reasons you give about historical awareness, that’s not a hopeful sign for financial planners who seem to mostly throw out self-serving rules of thumb that seem based on MPT.

Nick M
Nick M
3 months ago
Reply to  macropundit

Most financial advisors have no finance education whatsoever, let alone grad school. Even to hold the well-regarded CFP designation, they just need a bachelor’s degree in any field. So if they have a bachelor’s in French Poetry, as long as they can get 3 years experience advising people, they can have the highest financial advisor designation available.

As an aside, I do have a degree in Finance. An efficient frontier portfolio (i.e. a mix of assets touching the line of the efficient frontier) is only ever known after the fact. It’s a historical analysis of possible portfolios, and in any given time period, the efficient frontier portfolio can look dramatically different from the prior efficient frontier portfolio. So the idea that someone can sell you an efficient frontier portfolio is absurd, unless they also own a time machine, in which case I would be much more interested in the time machine.

Last edited 3 months ago by Nick M
Jonathan Clements
Admin
Jonathan Clements
3 months ago
Reply to  Nick M

I remember in the early 1990s that portfolios that sat on the efficient frontier included a hefty stake in Japanese stocks. The good news: The portfolios offered ample opportunity for tax-loss harvesting.

mytimetotravel
mytimetotravel
3 months ago

I am a great believer in the KISS principle – keep it simple, stupid.

Step One – figure out your asset allocation (mine is 50-50 now I am in my 70s).
Step Two – invest in low or no cost index mutual funds (I still have some stock in my former employer’s company and one higher cost managed global fund, which would generate capital gains if sold).
Step Three – rebalance if you stray from your asset allocation by more than a specified percentage (I use 2.5%).

I do know what the P/E ratio is, but I see absolutely no need to track it. I did once belong to an investment club and read company reports, which I found incredibly boring. I know that some people enjoy active investing, but I suspect they are a minority. Not a problem if kept to say two to five percent of the portfolio, could be hazardous to your wealth if indulged in for a whole portfolio.

Nate Allen
Nate Allen
3 months ago

Been seeing lots of spam lately as comments here. Is there a way to add some sort of “report spam” button, where if enough people click it, the post is hidden for review?

parkslope
parkslope
3 months ago
Reply to  Nate Allen

Jonathan, I assume you are able to delete spam. Is there a way to review all comments before they are posted?

Jonathan Clements
Admin
Jonathan Clements
3 months ago
Reply to  parkslope

I could set up the system to review all comments — but it would slow things down too much, I believe. I’ve been traveling this past week, which is why I haven’t been eliminating spam comments quite as quickly as I usually do. I just got home, however, so I’ll be able to respond faster in the weeks ahead.
Spam has definitely become a bigger issue this year. Back in January or February, a bot posted a spam comment on almost 400 pages. Fortunately, I noticed after eight comments, and then blocked the IP address. But the bot kept going….

Scrooge_McDuck88
Scrooge_McDuck88
3 months ago

Adam- you did it again… great practical snack size advice anyone can apply and become a better investor with. Thank you.

Ginger Williams
Ginger Williams
3 months ago

I always enjoy your posts, Adam, and frequently re-read them. This one is both exceptionally timely and classic. Timely and classic May seem like contradictions, but I’ve been seeing a lot of, “My portfolio’s declining where should I move my money?” lately. It’s not just coming from people in their twenties. Many people don’t really start paying attention to personal finance until they’ve established careers and families, so the generation experiencing their first bear market includes some people in their thirties who were adults but not yet paying attention to markets during the last downturn.

Lately, I find myself saying, “Remember, your 401k is a retirement account, money you won’t need for three or four decades. Don’t worry about the current balance so much. Stocks have the best chance of growth over the long term and you have a long time for them to recover.” Aesop’s tortoise and hare inevitably slip into those conversations.

Thank you for writing for Humble Dollar. I enjoy your thoughtful posts and research references.

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