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Warren Buffett or Mensa Investment Club?
You Decide
by Dave Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
January, 2008
You’ve probably heard of Mensa. It is a society that limits its membership to
people with IQ’s in the top 2% of the population. Mensa was founded in
England in 1946. Nowadays “Mensans” are found all over the world and in all
walks of life. The only requirement for membership is an IQ in the 98th
percentile or better. Mensa has over 100,00 members, about half of them in the
USA.
It turns out that Mensa has an investment club. Wow. That must be one heck
of a way to make money, right? The smartest people in the world making
investment decisions.
Well, not so fast. During the 15-year period 1986 to 2001, the S&P 500 had
average annual returns of 15.3%, but the Mensa investment club’s performance
averaged returns of just 2.5%. That is 84% worse than the index.
How could this be? An amusing article by Eleanor Laise (“If We’re So Smart,
Why Aren’t We Rich?”) details the smart-but-undisciplined investment
approach that reduced Mensa’s returns so badly. In brief, the investing
“strategy” of the club relied on trendy tech stocks, horrible timing, and over-
reliance on charting. The “strategy” was constantly changed. Some stock picks
were taken straight from Internet message boards. One member described the
approach as “buy low, sell lower.”
As Warren Buffett has said, “Investing is not a game where the guy with the
160 IQ beats the guy with 130 IQ….What’s needed is a sound intellectual
framework for making decisions and the ability to keep emotions from
corroding that framework.”
Mensa’s performance reminds us of another notorious group of smart people
who managed to blow up so badly that their mistakes threatened the world’s
economy. That would be hedge fund Long Term Capital Management
(LTCM), which melted down in 1998. Founded by experienced economists,
traders, and future Nobel prize winners, and aggressively run with the aid of
finely tuned computer models, LTCM had to be bailed out by the Fed, which
pulled together Wall Street’s leading banks to underwrite the bailout. The
LTCM incident is wonderfully documented in Roger Lowenstein’s book,
“When Genius Failed.”
Where is a copy of “Sensible Stock Investing” when you need it?
Why did these two groups of brilliant people fail as investors? Put simply, they
were overconfident, inconsistent, and blind to facts. All at the same time. In
other words, their failures were not caused by lack of conventional IQ-type
intelligence. Their failures were caused by lack of investing intelligence.
In 1996, Daniel Goleman wrote “Emotional Intelligence: Why It Can Matter
More Than IQ.” It provides a framework for understanding how really smart
people can make really dumb decisions. He wrote, “As we all know from
experience, when it comes to shaping our decisions and our actions, feeling
counts every bit as much—and often more—than thought....Passions
overwhelm reason time and again.”
The field of Behavioral Finance emerged about 30 years ago. It is devoted to
finding out how people really act when making financial decisions. Consistent
with Goleman’s thesis, Behavioral Finance has found that investors are often
influenced by emotion, and that therefore they make illogical, inconsistent, and
ill-informed decisions, despite their best intentions to act in their own self-
interest.
It turns out that humans, no matter how “smart” we are, are hard-wired with
several tendencies that don’t help very much when investing. Our judgment gets
skewed. Some of these common traits include:
• Loss aversion: Holding illogically onto a hopeless investment, hoping that
it will come back. People do not want to admit having made a mistaken
investment. They want to avoid regret over the loss—so they just don’t book it.
If they are arrogant too, they not only refuse to admit the investment is a loser,
they double down their bets while the doomed investment is tanking. (That’s
what Long Term Capital Management did.)
• Selling winners too soon: Locking in profits to create a feeling of victory.
Ta-dah! Unfortunately, winning stocks often keep going on up, and the investor
who sold too soon loses out on those gains.
• Forgetting that the real goal of investing is not to justify decisions you
made that got you to where you are right now. This mistake can lead you to
focus on the past rather than evaluate your investments on their future potential.
In short, stubbornness about your previous decisions convinces you that “the
market is wrong” and you will eventually be vindicated.
• "Preferential bias": Difficulty in changing an opinion once the opinion has
been formed. This causes incoming data to be processed selectively, with
supportive information favored and contradictory information downplayed or
even ignored. The end result is reduced objectivity. (Both LTCM and Mensa
probably did this.)
• Constantly changing tactics, following what’s hot (emotionalism) rather
than sticking with a sound long-term strategy. (Mensa did this. It adjusted its
“strategies” quarterly—meaning that they were not strategies at all, just short-
term, flip-flopping approaches.)
The Sensible Stock Investor needs to be as rational as possible, because over
time, the stock market tends to reward rational decisions. The market tends to
move stocks towards their intrinsic values. For example, if you paid too much
for a stock, over time the market will reduce your returns from that stock or
even turn them into losses as it brings the price of the stock back to what it is
really worth. Regretting the loss, failing to accept the sunk cost, holding onto the
loser too long, and/or failing to look ahead rather then back obviously do not
help you make the best decision in this situation.
Fortunately, we humans can counteract some of our right-brained emotional
tendencies by using our left brain to create tools and processes to increase our
“investing intelligence.” Such tools and processes include:
• A fact-based system for evaluating whether a company is a good company
• Calculating a well reasoned number as an advantageous price for its stock
• Resolving never to make snap judgments on fragments of information or
hot tips
• Writing out your investment goals
• Honestly assessing your appetite for risk
• Designing a strategy that is likely to lead to achieving your goals without
making you uncomfortable as to its risk
• Sticking to—perhaps automating—your strategic investment plans in a
disciplined fashion, ignoring short-term “noise” in the market
• Resisting the urge to “do something” all the time
• Reviewing and updating your approach annually as your life situation
changes and you learn more about investing
• Systematically reviewing your holdings—performing a reality check—
with your eye always on the future
The studies in Behavioral Finance clearly show that it is not your store of
market knowledge nor traditional IQ that are most likely to determine your
success as an investor. What counts more is whether or not you let your
emotions dictate your actions. In the end, you want to apply your intelligence
and objectivity to overcome self-defeating emotional tendencies in your
investing. That will help make you a Sensible Stock Investor, no matter what
you may score on standardized IQ tests.
You Decide
by Dave Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
January, 2008
You’ve probably heard of Mensa. It is a society that limits its membership to
people with IQ’s in the top 2% of the population. Mensa was founded in
England in 1946. Nowadays “Mensans” are found all over the world and in all
walks of life. The only requirement for membership is an IQ in the 98th
percentile or better. Mensa has over 100,00 members, about half of them in the
USA.
It turns out that Mensa has an investment club. Wow. That must be one heck
of a way to make money, right? The smartest people in the world making
investment decisions.
Well, not so fast. During the 15-year period 1986 to 2001, the S&P 500 had
average annual returns of 15.3%, but the Mensa investment club’s performance
averaged returns of just 2.5%. That is 84% worse than the index.
How could this be? An amusing article by Eleanor Laise (“If We’re So Smart,
Why Aren’t We Rich?”) details the smart-but-undisciplined investment
approach that reduced Mensa’s returns so badly. In brief, the investing
“strategy” of the club relied on trendy tech stocks, horrible timing, and over-
reliance on charting. The “strategy” was constantly changed. Some stock picks
were taken straight from Internet message boards. One member described the
approach as “buy low, sell lower.”
As Warren Buffett has said, “Investing is not a game where the guy with the
160 IQ beats the guy with 130 IQ….What’s needed is a sound intellectual
framework for making decisions and the ability to keep emotions from
corroding that framework.”
Mensa’s performance reminds us of another notorious group of smart people
who managed to blow up so badly that their mistakes threatened the world’s
economy. That would be hedge fund Long Term Capital Management
(LTCM), which melted down in 1998. Founded by experienced economists,
traders, and future Nobel prize winners, and aggressively run with the aid of
finely tuned computer models, LTCM had to be bailed out by the Fed, which
pulled together Wall Street’s leading banks to underwrite the bailout. The
LTCM incident is wonderfully documented in Roger Lowenstein’s book,
“When Genius Failed.”
Where is a copy of “Sensible Stock Investing” when you need it?
Why did these two groups of brilliant people fail as investors? Put simply, they
were overconfident, inconsistent, and blind to facts. All at the same time. In
other words, their failures were not caused by lack of conventional IQ-type
intelligence. Their failures were caused by lack of investing intelligence.
In 1996, Daniel Goleman wrote “Emotional Intelligence: Why It Can Matter
More Than IQ.” It provides a framework for understanding how really smart
people can make really dumb decisions. He wrote, “As we all know from
experience, when it comes to shaping our decisions and our actions, feeling
counts every bit as much—and often more—than thought....Passions
overwhelm reason time and again.”
The field of Behavioral Finance emerged about 30 years ago. It is devoted to
finding out how people really act when making financial decisions. Consistent
with Goleman’s thesis, Behavioral Finance has found that investors are often
influenced by emotion, and that therefore they make illogical, inconsistent, and
ill-informed decisions, despite their best intentions to act in their own self-
interest.
It turns out that humans, no matter how “smart” we are, are hard-wired with
several tendencies that don’t help very much when investing. Our judgment gets
skewed. Some of these common traits include:
• Loss aversion: Holding illogically onto a hopeless investment, hoping that
it will come back. People do not want to admit having made a mistaken
investment. They want to avoid regret over the loss—so they just don’t book it.
If they are arrogant too, they not only refuse to admit the investment is a loser,
they double down their bets while the doomed investment is tanking. (That’s
what Long Term Capital Management did.)
• Selling winners too soon: Locking in profits to create a feeling of victory.
Ta-dah! Unfortunately, winning stocks often keep going on up, and the investor
who sold too soon loses out on those gains.
• Forgetting that the real goal of investing is not to justify decisions you
made that got you to where you are right now. This mistake can lead you to
focus on the past rather than evaluate your investments on their future potential.
In short, stubbornness about your previous decisions convinces you that “the
market is wrong” and you will eventually be vindicated.
• "Preferential bias": Difficulty in changing an opinion once the opinion has
been formed. This causes incoming data to be processed selectively, with
supportive information favored and contradictory information downplayed or
even ignored. The end result is reduced objectivity. (Both LTCM and Mensa
probably did this.)
• Constantly changing tactics, following what’s hot (emotionalism) rather
than sticking with a sound long-term strategy. (Mensa did this. It adjusted its
“strategies” quarterly—meaning that they were not strategies at all, just short-
term, flip-flopping approaches.)
The Sensible Stock Investor needs to be as rational as possible, because over
time, the stock market tends to reward rational decisions. The market tends to
move stocks towards their intrinsic values. For example, if you paid too much
for a stock, over time the market will reduce your returns from that stock or
even turn them into losses as it brings the price of the stock back to what it is
really worth. Regretting the loss, failing to accept the sunk cost, holding onto the
loser too long, and/or failing to look ahead rather then back obviously do not
help you make the best decision in this situation.
Fortunately, we humans can counteract some of our right-brained emotional
tendencies by using our left brain to create tools and processes to increase our
“investing intelligence.” Such tools and processes include:
• A fact-based system for evaluating whether a company is a good company
• Calculating a well reasoned number as an advantageous price for its stock
• Resolving never to make snap judgments on fragments of information or
hot tips
• Writing out your investment goals
• Honestly assessing your appetite for risk
• Designing a strategy that is likely to lead to achieving your goals without
making you uncomfortable as to its risk
• Sticking to—perhaps automating—your strategic investment plans in a
disciplined fashion, ignoring short-term “noise” in the market
• Resisting the urge to “do something” all the time
• Reviewing and updating your approach annually as your life situation
changes and you learn more about investing
• Systematically reviewing your holdings—performing a reality check—
with your eye always on the future
The studies in Behavioral Finance clearly show that it is not your store of
market knowledge nor traditional IQ that are most likely to determine your
success as an investor. What counts more is whether or not you let your
emotions dictate your actions. In the end, you want to apply your intelligence
and objectivity to overcome self-defeating emotional tendencies in your
investing. That will help make you a Sensible Stock Investor, no matter what
you may score on standardized IQ tests.
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