How smart do investors need to be?
There are a lot of smart people out there. Twitter is full of investors showing off their smartness, via acerbic jokes, eloquent tweet-storms, and sometimes, full blown arguments with other smart people. Sometimes, the sheer number of smart people tapping out tweets, sending newsletters and hosting webinars feels overwhelming, making us feel positively stupid in comparison.
You don’t need to be an incredible genius to be a great investor. That’s self-evident, since if the smartest people were also the best at picking stocks, business school professors, economists and chess players the world over would be billionaires.
But what if we go further? But what if being a genius actually hurts your chances of generating returns? What if top-tier intelligence acts as a drag on performance?
Glass half empty.
Smart people aren’t necessarily predisposed towards negativity and doomsday scenarios for markets, but sometimes it can seem that way. We’ve lost count of the number of highly accomplished, supremely educated and articulate folks who have predicted the end of the world, seemingly at quarterly intervals, since we started investing professionally back in 2007.
And yet, the world keeps turning. We're not saying everything is perfect and markets won't fall at some point (in fact they always do eventually), but from where we’re sitting it’s just as important to worry about the market going up, as it is fretting about it going down.
Part of this is about the asymmetric nature of 24/7 news coverage. Media outlets have to find something to talk about, and they are biased towards newsflow that is (more often than not) negative, since it’s more engaging than good news. One thing you will never encounter on Bloomberg, CNN or CNBC is a headline that reads, “Nothing going on today”, or “Markets all good”. These guys are in the business of setting our pulses racing, our pupils dilating, and our fingers twitching on the keyboard. For a textbook example of this, look no further than Tesla.
Don’t fight the trend.
A lot has been written about Tesla, and a lot is yet to be written. We’re not seeking to add to the maelstrom, but we do find the fraught discourse surrounding this stock to be utterly fascinating. It seems to encapsulate everything that is wonderful and terrible about the investment game. It’s fair to say that if you’re not interested in Tesla, you’re not really interested in markets.
After a monumental rally in recent months, shares tumbled 17% on Wednesday, the biggest fall in eight years. But the thing is, critics have been calling for the company’s demise for years. As Josh Wolfe, a high profile critic of Tesla, very aptly put it in this tweet response to a question about his Tesla view:
“The stock price moving up or down reflects sentiment of investors (a voting machine). the fundamentals (a weighing machine) measure the biz.”
As we like to say, we invest in stocks not companies and the difference is substantial.
Quoting the forensic analysis and investigative journalism of TeslaQ is impressive and it is remarkable the amount of quality work that has been done as result of this twitter vigilante handle. We really admire what these guys are doing). In the short to medium term however it doesn't get you very far when you’re betting against millions of retail investors and large scale passive flows. We are reminded of Keynes’ classic profundity, “Markets can stay irrational longer than you can stay solvent.” Or, put more prosaically, “Don’t fight the trend.”
Fund managers slagging off retail investors isn’t cool. Rather than looking down on those investing their 401ks and annual bonuses, why not seek to work with them by gaining a greater understanding of the structural reconfiguration of markets in the era of passive flows?
Higher degrees.
Speaking of Keynes, those seeking to profit from Tesla would do well to remember his famous Beauty Contest, which teaches us that investors shouldn’t price shares based on what they think their fundamental value is, but rather on what they think everyone else thinks their value is. Or, more precisely, what everybody else would predict the average assessment of value to be. Keynes said:
“We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth, and higher degrees.”
The dangers of pure mechanistic thinking.
It’s not smart people per se that dominate the investment discourse. Rather, it’s mechanistic thinkers. They tend to be drawn to value based investing and deep fundamental analysis (perhaps it all started when Benjamin Graham called his type of bottom-up investing “Intelligent”) and as a consequence, the internet is swimming with meticulously constructed thought pieces extolling the virtues of the deep value in x company (and it is usually companies, not stocks, that get the treatment), or lamenting the global central banks and how we live in an unsustainable environment (which may very well even be true).
A lot of the time the mechanistic view tends to be retrospective, relying on past results to project future outcomes. This might work in markets that are functioning “properly”, but the concept of markets functioning according to some predetermined mode of behaviour is a fallacy. In truth, classical models struggle to cope with markets that are becoming more correlated, chaotic and random.
Mechanistic thinking can also fail to mitigate psychological biases that can unravel otherwise stellar returns when greed and fear set in. We’ve previously spoken about these in some depth, underscoring our belief that success in investing is as much about not losing money as it is about making it. George Soros says, “It’s not how right or wrong you are that matters, but how much money you make when right and how much you do NOT lose when you’re wrong.”
On the importance of temperament.
Fund managers need to be smart. They don’t need to be intellectuals. A wise man once said that success in investing has nothing to do with IQ, once you breach the level of 125. To us, that sounds about right.
Investing isn’t rocket science. It’s far, far harder. It requires something they don’t teach at business school, something that helps managers to resist the primitive urges that lead them to lose money. That thing is temperament. The dictionary definition of this word contains two entries, both of which help to explain what we’re driving at:
“A person's or animal's nature, especially as it permanently affects their behaviour.” – This reminds us of the fact that we’re all animals, with primitive, self-destructive urges that can damage our performance as investment managers.
“The adjustment of intervals in tuning a piano or other musical instrument so as to fit the scale for use in different keys.” –This perfectly encapsulates our understanding of what is required to navigate markets in 2020. Through our iterative approach to putting on positions, we seek to tune our portfolio to fit the mood music of the market.
Such an endeavour requires great skill, and great artfulness, too, both of which we are developing as we progress on our journey. We are not trying to drown out the noise, change people’s opinions with our brilliance, or rail against the irrational injustice and of a market that seems to make things up as it goes along – we are trying to tap into it, to complement what other people are doing, to create something beautiful.
The left brain / right brain dichotomy is another effective, – albeit somewhat simplistic – way of looking at this. Of course, recourse to both hemispheres is essential, but rather than playing down the right brain in favour of intellectual elitism and snobbery, we seek to tap into it, acknowledging the complexity and reflexivity of markets. Of course, like anything in life, balance is needed. The left brain helps us to dispassionately observe the minutiae of what’s occurring in markets and use logic to construct and test hypotheses. But the right brain enables us to understand the complex web of stories that constitute markets.
Go into the story.
As we’ve pointed out before, the poetic theory of "Negative Capability", which prizes intuition and uncertainty above reason and knowledge, is an important touchpoint for investors. Creative genius, according to John Keats, requires people to experience life as an uncertain domain that gives rise to a diverse array of perspectives. Cast in this light, the world is a complex and fluid landscape that requires complex and fluid responses in order to render it intelligible. Sounds a lot like markets.
Underlying fundamentals are important and not to be overlooked. They are, if you like, the details of the story, the content that decides whether a stock is investable or not. But this content needs to exist within a context that is relevant, durable and timely. And that context is the story of a stock, a market, an economy that modulates the relationship between capital and opportunity. This is the force that drives the disconnect between book value/fundamentals and price.
Could, not should.
Ultimately, you do need to be smart to be a successful investor. But intelligence only gets you so far. It’s a hygiene factor. The market doesn't care about us and our university grades, or our connections on LinkedIn.
It does what it wants to do. It is never wrong.
That is why mechanistic, or conventional thinking is so dangerous for fund managers. Focusing on what should happen is the wrong approach – instead, we must focus on what could happen. It’s about being street-wise, considering multiple paths and unintended consequences, saying no to the Kool-Aid. It’s about being wired the right way.
None of this is possible without a healthy dose of humility. The problem for managers is that humility doesn’t come cheap. It comes through messing up. We find it easy to be humble, because we have much to be humble about. We try to resist single sources of “truth”, gathering input from diverse sources. And we try to keep an open-mind, admitting that we have no idea what will happen in future and instead, considering multiple paths and outcomes.
We prefer it that way and we believe that our investors will, too.