The superb Abnormal Returns has a post “Investing by the seat of their pants,” which, among other things, discusses William Bernstein’s conjecture that “only a tiny fraction, 1 in 1000, investors have the skills to become truly competent investors.” In the preface of his new book, Bernstein suggests four abilities successful investors must enjoy (via Information Processing):
First, they must possess an interest in the process. It is no different from carpentry, gardening, or parenting. If money management is not enjoyable, then a lousy job inevitably results, and, unfortunately, most people enjoy finance about as much as they do root canal work.
Second, investors need more than a bit of math horsepower, far beyond simple arithmetic and algebra, or even the ability to manipulate a spreadsheet. Mastering the basics of investment theory requires an understanding of the laws of probability and a working knowledge of statistics. Sadly, as one financial columnist explained to me more than a decade ago, fractions are a stretch for 90 percent of the population.
Third, investors need a firm grasp of financial history, from the South Sea Bubble to the Great Depression. Alas, as we shall soon see, this is something that even professionals have real trouble with.
Even if investors possess all three of these abilities, it will all be for naught if they do not have a fourth one: the emotional discipline to execute their planned strategy faithfully, come hell, high water, or the apparent end of capitalism as we know it. “ Stay the course ” : It sounds so easy when uttered at high tide. Unfortunately, when the water recedes, it is not. I expect no more than 10 percent of the population passes muster on each of the above counts. This suggests that as few as one person in ten thousand (10 percent to the fourth power) has the full skill set. Perhaps I am being overly pessimistic. After all, these four abilities may not be entirely independent: if someone is smart enough, it is also more likely he or she will be interested in finance and be driven to delve into financial history.
But even the most optimistic assumptions — increase the odds at any of the four steps to 30 percent and link them — suggests that no more than a few percent of the population is qualified to manage their own money. And even with the requisite skill set, more than a little moxie is involved. This last requirement — the ability to deploy what legendary investor Charley Ellis calls “ the emotional game ” — is completely independent of the other three; Wall Street is littered with the bones of those who knew just what to do, but could not bring themselves to do it.
Bernstein’s is an interesting thought experiment. Steve Hsu at Information Processing, after considering the abilities identified by Bernstein, categorizes them as follows:
…the right interests (history, finance theory, markets — relatively easily acquired, as these subjects are fascinating), personality factors (discipline, controlled risk taking, decisiveness — not so easily acquired, but can be improved over time) and intelligence (not easily acquired, but perhaps the threshold isn’t that high at 90th percentile).
Bernstein’s list and Hsu’s categorization of it feels right. Whether it winnows the universe of competent investors down to 1 in 10,000 is open to debate, but I think few would have a genuine quibble with the content of the list. The only other element that I would suggest – and it is possible that it’s already captured within Bernstein’s list as “emotional discipline” – is the ability to think and act counterintuitively.
There are many examples of strategies that are counterintuitive and produce above-market returns. Value is a counterintuitive strategy. Glamour feels like a better bet than value, but studies have shown over and over again that value outperforms glamour or momentum. Tangible asset value – liquidation value investing or low price-to-book value investing – is counterintuitive even to practitioners within the value school, who predominantly seek Buffett-style earnings and growth. The counterintuitive element is that companies within the lowest price-to-book quintile – not, by any means, earnings machines – tend to grow earnings faster than companies in the highest price-to-book quintile, a phenomenon that value investors recognize as “mean reversion”. Even with the liquidation value investment world itself, the counterintuitive strategy – buying loss-making net nets – outperforms the intuitive one – buying net nets with positive earnings.
This suggests to me that the ability to understand a concept from an intellectual standpoint is a necessary but insufficient condition for competent investing. One must also be able to suspend instinct or intuition or disbelief and follow intellect through to action. That seems to me to be a rare trait, but one that I believe can be developed. Is it possible that, if one follows a counterintuitive strategy for long enough and succeeds with it, it becomes intuitive? I think so, but I’d like to see what you think too.
Update
I knew I was asking for it when I wrote the panglossian, “I think few would have a genuine quibble with the content of the list.” An astute reader has a quibble, and I’m embarrassed to say that I think he’s right:
I flatly deny Bernstein’s assertion that “investors need more than a bit of math horsepower.” I cite the highest authority:
1. Ben Graham explicitly warned against “calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra.” Indeed, “whenever [calculus] is brought in, or higher algebra, you could take it as a warning signal that the operator is trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.”
2. “If calculus were required,” Buffett has said, “I’d have to go back to delivering papers. I’ve never seen any need for algebra … It’s true that you have to divide by the number of shares outstanding, so division is required. If you were going out to buy a farm or an apartment house or a dry cleaning establishment, I really don’t think you’d have to take someone along to do calculus.”
3. Elsewhere, Buffett has said “read Ben Graham and Phil Fisher, read annual reports, but don’t do equations with Greek letters in them.”
4. In one of his books, Peter Lynch recounts at length that the mathematical stuff he learnt in MBA-School were hindrances rather than helps, and that “the arts/philosophy side” (or words to that effect) of his education have stood him in much better stead. Indeed, I recall Lynch saying something like “all the maths you need to invest competently you learnt in primary school.”
5. The “Ben Graham, Meet Ludwig von Mises” paper you cited a while back discusses the Austrian conception of value, markets and entrepreneurial discovery. None of these things rely upon maths, probability or stats. But they do, I think, hinge upon the ability to think unpopular or contrarian thoughts — like adherence to the Austrian School!
Mind you, I’ve never liked Bernstein and indeed have long thought that he does far more harm than good. This assertion is but one in a long list of silly things he’s said over the years. In short, not only is mathematics NOT a necessary condition of successful investment; it may be a sufficient condition of investment failure.
[…] Counterintuition – The superb Abnormal Returns has a post “Investing by the seat of their pants,” which, among other things, discusses William Bernstein’s conjecture that “only a tiny fraction, 1 in 1000, investors have the skills to become truly competent investors.” In the preface of his new book, Bernstein suggests four abilities successful investors must enjoy (via Information Processing). […]
LikeLike
[…] scorned companies are ignored like value stocks, which creates the opportunity for contrarian bet. I love a counter-intuitive strategy. Possibly related posts: (automatically generated)Blogging Community still very bullish – […]
LikeLike
[…] too far into the future. To exploit the flaw in intuitive forecasts – you know how I love a counter-intuitive strategy – they argue that contrarian investors should sell stocks with high past growth as well as […]
LikeLike
When Bernstein mentions that you need an understanding of mathematics, I think he means that you need a conceptual clarity of the laws of probability and a grip on the basic concepts of statistics.
One does not need an advanced degree, as he does not means that. If you do not have an idea of where you stand vis a vis the odds of the event occurring or not, over a period of time, you will lose your capital.
Graham and Buffett are very superior intellects. Let us admit to that. They will for sure be in the 1/10000 which Bernstein has mentioned. I can tell you with my experience with brainy guys and girls, what they can see through with amazing clarity at first sight, will take a lot of explanation for guys on the average side of the normal curve, to get an understanding.
This is applicable even for any other art / skill like Music, Sports, Acting / Surgery etc. Some set of people ( may be in the same fraction as mentioned for finance ) only are superb intellects in that field.
I dont think anyone will say that Music or Surgery is the domain for everyone without basic knowledge of the field.
I am surprised ( actually I should not be) how that is assumed for investing.
LikeLike
that reader makes an interesting point, there are certainly many many many successful investors that base their investments solely on math though (ie: nearly every technical trader).
So I pose the question:
what if value investing is NOT what suits your personality type very well (this IS possible, just look at Renaissance fund or any successful non-value investors of which there are countless). Then if you don’t have some math horsepower in your head to be able to understand alternative investment philosophies you will be limiting yourself. Potentially limiting yourself from an investment style that would be ideal for you.
LikeLike
[…] one important aspect is the ability to "stay the course," even though it may be counter-intuitive.Close Forward this […]
LikeLike
Excelente post.
LikeLike
You could write this article about any profession: doctors, lawyers, carpenters even.
So many experts in the field seem to love writing articles about how nobody else can possibly succeed. Sure, it takes a few years of study and dedication… but doesn’t it take 4 to 8 years to become a lawyer/doctor. And even after 8 years of education — I still wouldn’t want a young doctor operating on me. So should he just give up?
There are many ways to make a living trading. The key is to figure out which way best suits your personality. Then stick to it no matter what. And most importantly don’t give up.
LikeLike