A few weeks back, I discussed the notion of “the four horsemen of the investor apocalypse.” A concept proposed by former Morningstar CEO Don Phillips, these are factors that, in his experience, tend to lead investors off course. But what about success—what are the factors that contribute to success for investors?
Warren Buffett has commented on this question. “Investing,” he says, “is not a game where the guy with the 160 IQ beats the guy with a 130 IQ…You need to be smart, but not a genius.” In his usual plainspoken way, he adds, “If you have a 150 IQ, sell 30 points to someone else.”
If not IQ, then what is most important for investors? “Rationality,” Buffett says, “is essential.” Building on that—and to borrow a phrase from Phillips—below are the factors you might call the four horsemen of success for investors:
1. Knowledge. Of course, information is useful. But what kind of knowledge specifically is most helpful to investors? Two areas seem most important. The first is history. The standard investment disclaimer states that “past performance doesn’t guarantee future results.” That’s undoubtedly true. The future may not look like the past. Nonetheless, it’s the best information we have to go on. In particular, I think it’s important to study past booms and busts. Historically, the stock market has delivered an average return of 10% per year. That sounds like a nice round number, and it is. Trouble is, that 10% comes at the expense of a lot of variability. There have been periods when the market has lost 50% and taken years to climb its way back. That’s why I see it as invaluable to have a sense of past downturns, including their frequency, depth and duration.
I would also learn some textbook investment theory, including the principles of investment valuation. What’s the meaning of a price/earnings (P/E) ratio, and what might be a normal P/E range for different types of stocks? These simple metrics, in combination with some knowledge of history, can be invaluable, especially the next time the market goes into one of its regular tulip-like frenzies.
2. Time and experience. Of course, there’s only so much anyone can learn from a textbook. That’s why experience is critical. Something I’ve observed over the years is that stock market bubbles seem to come along only infrequently. They don’t happen every year, or even every five years. It’s more like every twenty years. Why is that? I think it has to do with investors’ memories. With each boom-and-bust cycle, a new generation of investors sees firsthand what manias look like—and how they end. They then carry those lessons with them. But after some years go by, a new generation comes along—one that was too young to have seen the pain inflicted by the prior cycle. It’s then their turn to learn these lessons.
I often talk about my nephew, who’s twenty-five. Until this year, the stock market had been rising, almost without stop, since he was in middle school. It’s no surprise, then, that he participated in the Robinhood/meme stock frenzy last year, buying options and other speculative investments. But now, for better or worse, he’s seen how these frenzies turn out. I suspect that investors in his generation will now be more cautious.
It’s cold comfort, though, to suggest that investors need to learn the hard way. That’s why I recommend a shortcut. Learn from investors who have lived through major historical events. Among the most thoughtful is, of course, Warren Buffett. If you read his annual letters, he often frames his thinking in historical terms. Also worth reading is the work of Howard Marks, an investment manager who started his career in the 1960s, during the Nifty Fifty boom. That was the predecessor to the 1990s dot-com boom and looked a lot like it. Marks has for years been writing memos to his clients. They are all available on his firm’s website. Collectively, they represent one of the best courses in market history available anywhere.
3. Mindset. For several decades, beginning in the 1950s, the investment world believed in a concept known as Modern Portfolio Theory. This was a mathematical approach to constructing a portfolio, and it was viewed as the bedrock theory of the investment profession. But then in the late-1970s, two psychologists, Amos Tverksy and Daniel Kahneman, upended that thinking with an argument that seemed radical at the time. Math is important, they said, but so is psychology—maybe even more important.
If you listen to Warren Buffett, this comes through clearly. In his public comments, he spends much less time talking about numbers than he does about psychology and decision-making. In fact, most of Buffett’s pithy aphorisms boil down to the same basic message: “Just be sensible.” This may seem easier said than done. That’s why I think it’s worth taking time to learn about the major cognitive biases discovered by Tversky, Kahneman and others. In particular, it’s worth learning about prospect theory, recency bias and anchoring.
4. Luck. This last factor—luck—might seem out of place. After all, there isn’t much anyone can do to control their own luck. But I still see it as one of the four horsemen of success. While you certainly can’t predict your own luck, there is something you can do about it: You can structure your plan so you’re well positioned to harness it to your advantage when it does come along. This applies to both good luck and bad luck.
In the category of good luck, you might receive a promotion or a windfall. These fit in the proverbial “good problem to have” category. Still, it’s good to have a plan. You might simply add those dollars to your existing investment strategy. Or you could focus on a specific purpose, such as paying down your mortgage. Whatever you choose, though, it’s best to be intentional about it. Without a plan, unfortunately, good luck has a habit of turning into bad luck.
Planning for bad luck is of more concern. In general, you want to be prepared for any eventuality—within reason—that might set your plan behind. How can you do this? It’s the flip-side of planning for good luck. Have a Plan B and maybe a Plan C mapped out for a rainy day. That might seem like a depressing exercise, but more than one person has reported to me that it actually made them feel better, not worse, to think this through.
So what about intelligence? Why, in Buffett’s view, is that less important? It may be because it can cut both ways. On the one hand, there’s the Dunning-Kruger effect. This describes people who don’t have high IQs but nonetheless suffer from overconfidence because they can’t judge their own abilities. The classic example was McArthur Wheeler, who tried to disguise himself during a bank robbery by applying lemon juice to his face. He was quickly caught.
But on the other hand, genius hardly guarantees success. The most famous case in the investment world was probably the hedge fund Long-Term Capital Management. It failed spectacularly despite having two Nobel laureates among its founders. The fund’s obituary was a book titled When Genius Failed. The reality, though, is that wasn’t the only case in which genius failed. It’s just the most notable. On a more day-to-day basis, overconfidence can also be a pitfall for those who are highly competent. That’s why I see the four horsemen above as being much more deserving of investors’ time and energy.