Smart People, Dumb Things
Stock markets were positive last week. The S&P 500 was up about 1% on the week, while the Nasdaq doubled that return with a 2% weekly rise after a big up day on Friday. The Dow, which had a 13-day winning streak snapped on Thursday, was also up on the week.
In bull markets and bear markets, there are always examples of smart people doing dumb things. Smart people went bust at Long-Term Capital Management. Smart people invested too much money with Bernie Madoff. And so on.
Those mistakes, and plenty of others, were avoidable. Things like avoiding leverage and doing proper due diligence go a long way.
But why are controllable, avoidable mistakes so often made in financial markets by people that should have been able to avoid them? In a 1998 interview on Adam Smith’s Money Game, Warren Buffett touched upon this topic:
The money doesn’t go to the people with the highest I.Q. There would be a very poor correlation between I.Q. and investing and results. And you say to yourself why does somebody with a 500-horsepower motor only get 100-horsepower out of it? And I would say that if you look at the intellect as being the horsepower that’s available, but you look at the output as reflecting the efficiency of that motor, it is rationality that causes the capacity to be translated in output.
Now, what interferes with rationality? It’s ego. It’s greed. It’s envy. It’s fear. It’s mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it’s not because we’re so smart, it is because we’re rational and we very seldom let extraneous factors interfere with our thoughts. We don’t let other people’s opinion interfere with it…. We try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people’s behavior. And those are the factors that cause smart people to get bad results.
Ego and emotions explain a lot.
People tend to view themselves as more intelligent or more skilled than they sometimes are at a given thing. In the stock market, this often leads to confidence, which often leads to big position sizes or leverage, or both, which can end in disaster if that confidence is misplaced.
And those emotions. Those silly emotions that cause problems in all walks of life. Controlling emotions is a tricky thing. Part of it is nature—it’s easier for some people than others. Part of it is nurture—teaching yourself to Know Thyself.
But mistakes happen, even when you’re aware of the ego and emotions that cause them. So it’s best to prepare for their eventuality by paying attention to your downside, doing your due diligence, being careful with leverage, and diversifying enough so that one big mistake can’t take you out of the game.
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