It takes more than just the thing we usually refer to as “intelligence” to become a truly intelligent investor. The successful investor combines the kind of intelligence measured in I.Q. points with common sense, emotional balance, and street smarts.
Intelligent Investor Scenario #1 — You Learn of an Exciting Development
You see an article describing a miracle drug that has recently been approved by the government. You are able to envision many ways in which the company producing the drug can make profits from it. Can you increase your investment returns by investing in the company producing the drug?
You probably cannot increase your investment returns by investing in the company producing the drug. There are lots of people who know about the value of this drug. The price of the stock of the company producing the drug probably already reflects the intelligence that you are trying to make use of here.
Intelligent Investor Scenario #2 — You Discover Something That Most People Don’t Know About
You hear from several friends that they like a new chain restaurant that now operates from a single location but that plans to open at hundreds of locations within a few years.
Your odds of a good outcome are slightly better in this scenario. But they still are not terribly good. The odds are better because the intelligence you would be putting to use would be a more specialized form of intelligence.
Not many investors have friends who have tried out this restaurant concept, so you have an edge. However, there may be a good number of investing professionals following developments, and they may either have heard the same sort of feedback that you have heard or have heard better-balanced reports (giving them a greater edge). This intelligence is not public, but it is questionable whether it is intelligence that can be reliably put to use increasing investment returns.
Intelligent Investor Scenario #3 — You See An Investor Overreaction
Litigation is brought against a company with a long record of good earnings, causing its price to drop to seemingly absurd low levels. You had considered buying shares in the company at a far higher price, and are now tempted to buy despite the litigation because the price has dropped so low.
In these circumstances, I think that your odds of a successful long-term outcome are good. In this case, you are not trying to take advantage of factual information that can be exploited more effectively by others. You are seeking to take advantage of your understanding that investing is primarily an emotional endeavor, and that investors often overreact to news developments of this sort.
So long as the company’s long-term prospects really are solid and so long as you have what it takes to wait for the bargain purchase to pay off, your odds of a successful outcome are good. There are always exceptions, of course. But if you seek to take advantage of a number of scenarios of this sort over the course of a lifetime and do the research work needed to make the edge you obtain by doing so a genuine one, I think you stand a reasonable chance of being rewarded for the effort.
Intelligent Investor Scenario #4 — You Accept Your Own Limitations
You lose big on a stock you thought was a sure winner and conclude that you are better off investing in a broad index.
There are two types of intelligence at work in this scenario. The I.Q.-type intelligence tells you that indexing provides diversification benefits you could not obtain by investing in a basket of individual stocks. Even more importantly, choosing index funds evidences an emotional maturity that is likely to pay off big in the long run.
Choosing to invest in an index because you doubt whether you have what it takes to successfully pick individual stocks is a sign of emotional intelligence. This is why Warren Buffett, the greatest stock-picker of all time, says that most middle-class investors would be better off in index funds.
Intelligent Investor Scenario #5 — Your Humility Is Rewarded and Turns Into Pride
After several years of indexing in which you obtain outstanding returns, you stop paying any attention to investing at all, and put everything on autopilot.
This is how indexers get into trouble. It is not emotionally healthy to come to believe that indexing is the final solution to the investing problem.
Indexers that get arrogant forsake the humility that makes indexing so appealing a concept. If your returns have been so good as to persuade you that you need not even concern yourself with educating yourself about your investing choices anymore, stocks are probably overvalued and headed for a trip down a waterfall.
Intelligent Investor Scenario #6 — You Push Feelings of Panic Aside
Stock prices drop dramatically and you give thought to lowering your stock allocation. After talking the idea over with some friends, however, you are persuaded that you must hold for the long term to be successful. So you force yourself to ignore your feelings of panic.
Buy-and-hold is indeed the way to go. But an approach to buy-and-hold that requires that you ignore feelings of panic is unlikely to stand the test of time. Buy-and-hold can be practiced successfully only by investors who have informed themselves well of how stocks have always performed in the past and who thus possess confidence that their stock allocations are the right ones for them.
If you are feeling panic, there is a reason, and you had better give serious consideration to the idea of lowering your stock allocation before prices drop even lower and the prospect of doing so becomes even less appealing. This is a case where the investor with street smarts would recognize the holes in the conventional arguments for a blind buy-and-hold strategy, and who would profit from possessing this form of intelligence.
Intelligent Investor Scenario #7 — You Feel Reluctant to Move Outside Your Comfort Zone
You elect to invest only in a broad U.S. index because you do not feel that you understand overseas markets well enough to have confidence in investments you make in them.
Diversification is a good thing. All things being equal, it would be better not to own stocks only in a single market. The other side of the story, though, is that having enough confidence in your investment choices to stick with them for the long term is critical.
I see the choice made in this scenario as a reasonably good use of emotional intelligence. It would be best to combine it with a resolution to learn more about foreign markets over a specified length of time.
Intelligent Investor Scenario #8 — You Feel Drawn to Push Beyond the Barriers of the Comfort Zone Accepted by Many Others
You read an article about the losses suffered in the Japanese market and conclude that it is not safe to be invested in a single market, even the U.S. market.
In this case, the same sort of emotional insight being put to use in Scenario 7 is being put to use supporting a contrary conclusion. This decision is also emotionally smart.
Investors who do not feel comfortable investing overseas probably should not invest overseas (although it would be good for them to make some efforts to overcome the discomfort). Investors who do not feel comfortable investing solely in the U.S. market probably should not invest solely in the U.S. market.
Intelligent Investor Scenario #9 — You Permit Greed a Ride in the Driver’s Seat
A terrorist attack causes a plunge in stock prices. You consider increasing your stock allocation before prices return to their former levels with the thought that you might be able to make a killing within six months or so.
Color me skeptical. Nothing like this has happened before. How can you be sure that prices will return to their former levels within six months? How will you react if prices are even lower in six months?
Intelligent Investor Scenario #10 — You Find the Middle Ground Between Fear and Greed
Your response to a terrorist attack is to increase your stock allocation with the thought that you will see good results somewhere in the long-term future.
This is a case where emotional intelligence can pay off handsomely. There is no guarantee that prices will ever recover if we end up in a third world war. The risks associated with this move are real. The other side of the story is that you would be gaining a share in the profit-generating capacity of U.S. businesses at a far better price than was paid by those who were going with high stock allocations prior to the terrorist attack.
We’ve seen our way through dark times before, and those willing to put money forward the next time we are put to the test in a vote of confidence that we will again stand to win big down the line in the event that history repeats.
Intelligent Investor Scenario #11– You Pay Heed to Appropriate Fears
Prices rise dramatically and you lower your stock allocation on the thinking that the value proposition represented by a stock purchase is no longer as strong as it was when you set your allocation.
This is a street-smart move. The ivory-tower eggheads who say that the market is efficient won’t cover your losses in the event that a change in the price paid for stocks really does affect the long-term return provided, just as common sense and the historical stock-return data and a good number of experts tell us it must. I have nothing against ivory-tower eggheads as a general policy. In this case, though, their claims just do not add up, and I feel that I must invest my money in a way that makes sense to me.
Intelligent Investor Scenario #12 — You Ignore Appropriate Fears
You figure that the ivory-tower eggheads are so much smarter than you that they must be right. So you ignore valuations even when prices rise to frighteningly high levels.
I don’t view it as a street-smart move to put all your trust in experts. They have a lot to teach us. As a general rule, we certainly should learn from them what they are willing to teach us. If you don’t understand the intellectual justification for the advice being offered, though, you’re not going to have the confidence in it to stick with it when it is subjected to a real-world challenge.
It’s one thing to adopt tips offered by others that make good sense to you. It’s something very different to try to gain a free ride on the strength of someone else’s reasoning power.
But what do I know?