Author and Fund Manager Frederik Vanhaverbeke says there is one thing that separates top investors from the average investor" investor intelligence. Here he explains how you can learn from the masters and improve your returns.
People with experience in the stock market who are honest with themselves will admit that beating the market is hard. Investing is indeed a highly competitive occupation as numerous smart and well-heeled investors constantly try to eliminate every possible bargain. Nevertheless, as I explain in my book Excess Returns: a comparative study of the methods of the world?s greatest investors there are plenty of investors who have proven that it is possible to beat the market consistently over long periods of time.
Take a look at figure 1, which illustrates by what extent a set of top investors has beaten the market over (a large part of) their career. The figure shows their annual outperformance over the S&P 500 index (with dividends reinvested) as a function of the length of their track record. Even skeptics have to admit that beating the market by about 10% a year over half a century, as did Warren Buffett and Shelby Davis, is not a lucky shot. Likewise, the impressive outperformance of Joel Greenblatt, who managed to turn $1,000 into $840,000 between 1985 and 2005, can hardly be attributed to luck.
[FIGURE 1 removed]
It inspired me to introduce the concept of ?investor intelligence.? In the same way that intellectual intelligence and emotional intelligence are measures of a person?s intellectual (IQ) and interpersonal capacities and skills (EQ) respectively, investor intelligence is a measure for how a person holds up against the challenges of the market place. Hereunder I explain in more detail what constitutes investor intelligence.
Cognitive biases and how top investors deal with them
Top investors pointed out many decades ago that the human brain is not wired correctly to deal with the stock market. Nowadays this is fully acknowledged in the modern academic discipline of Behavioural Finance. Investing appears to be a complex and highly emotional activity that constantly triggers the so-called reflexive system of the human brain. This system prompts investors to take rash and irrational decisions all the time. In fact, it turns out that investors constantly trip up due to a wide range of cognitive biases that spring from one?s reflexive system. Many of these cognitive biases are remnants from a distant past when they were crucial for human survival. But they are very harmful in the stock market. Figure 2 gives an overview of the most important cognitive biases (arranged as the outer rectangle) and summarises the main investment mistakes they are responsible for (centre of the rectangle).
Just as top investors were the pioneers in detecting these cognitive biases decades before academics showed interest, they are the pioneers in coming up with solutions. They actually use a three-pronged defense against cognitive biases: the right attitudes and mindset, stringent process requirements, and some practical habits. Let?s take a closer look at some cognitive biases and at the way top investors deal with them.
Some cognitive biases lure investors into unfortunate buy and sell decisions. Typical errors are overtrading (i.e., buying and selling too frequently), buying high, selling low, selling winners and hanging on to losers. The strongest bias that is responsible for these errors is probably herding behaviour. It feels safe for investors ? especially when they are insecure or uninformed ? to buy what others buy and to sell what others sell. Irrational trades are also prompted by people?s tendency to look for patterns in stock (price) behaviour. In reality, though, most patterns are illusory and caused by random noise.
Overconfidence in one?s ability to time purchases and sales correctly is yet another reason why so many investors constantly move in and out of stocks. Also the asymmetric loss aversion is responsible for ill-considered trades. As the pain of a loss is twice as intense as the pleasure of a similar gain people want to get rid of losses. So, investors often sell stocks close to their bottom to make the pain go away. Closely related to this is the overreaction bias, which states that the release of bad news often triggers (exaggerated) panic selling. Conversely, investors sometimes desperately hang on to losing stocks due to mental accounting. They reason that as long as the stock is not sold the loss is not ?realised? and one can still nurse the hope to get out even. Hanging on to losers is often exacerbated by anchoring, which is the tendency to use certain price levels as a reference. Believing that the price at which a stock has been purchased previously is fair or cheap, investors refuse to sell their shares (far) below that purchase price.
Top investors protect themselves against irrational trades through emotional detachment, patience, independence, knowledge, and a focus on the long term. Thanks to hard work they build discretionary and thorough knowledge which enables them to ignore the crowd, and stay in unconventional market positions. They accept with equanimity that they will suffer setbacks and incur temporary losses on their way to riches. And thanks to their patience and their unrelenting focus on the long term, they avoid the pitfall of constantly switching positions in anticipation of short-term market moves, economic market forecasts or political considerations.
[Figure 2 removed]
Top investors also adopt some effective habits to limit the occurrence of cognitive biases. Knowing that price changes trigger many of the cognitive biases discussed above, they try to limit their exposure to price movements. Warren Buffett, for instance, has no Bloomberg terminal on his desk and is not interested in live quotes. The legendary Walter Schloss even didn?t have a computer, and monitored his holdings merely through the price quotes in newspapers. Another habit that a top investor like David Einhorn applies to counter the overreaction bias is to insist on time-out after sudden bad news. He argues that one usually can?t think straight when unexpected bad news breaks and that the many other disgruntled investors tend to punish the stock too much. Doing nothing for a few days (or weeks) and reevaluating the company after the dust has settled makes more sense to him.