Tuesday, April 7, 2015

Why does very high IQ not give you an edge in investing?

“You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.”
- Warren Buffet

In the hedge fund world you find fund manager after fund manager pitching the smartness of their investment team to the investors. Some will only hire out of the Ivy leagues. Some will have an interview process that could match that of the most competitive companies in the world like Google or Facebook or General Electric. The results, however, don’t seem to correlate with IQ. Take the example of Long Term Capital management (LTCM). It was led by John Meriwether and had Myron Scholes and Robert Merton on the board who shared a Nobel prize! 

They had the smartest investment team the world has ever seen and could probably compete with top research teams at the world’s top labs and universities. They, under the assumption that inefficiencies in the markets will converge put on trades with razor thin margins and took lots of leverage. As we already know markets can be irrational longer than anybody can stay liquid. There are several examples of irrational markets across the globe. Most closed end funds like Alliance trust in the UK trade at a discount to the securities they hold. And in the case of Alliance trust they mostly hold highly liquid securities and thus very little debate on the market value used to calculate the NAV. Anyways LTCM eventually got itself into a position where it had so much leverage and was such a large counterparty risk that it’s downfall would have brought down the entire financial system. Several banks under the supervision of the Fed bailed out LTCM in order to avert a financial crisis. There is a wonderful book about the LTCM debacle if you are interested in the details called “When Genius Failed: The Rise and Fall of Long-Term Capital Management” by Roger Lowenstein.

LTCM is not the only example of smart people losing money in the markets. There are several others. Buffet routinely says that smarts don’t really help you in the markets. The question really is why don’t the smarts help? IQ and intelligence have a few facets to them. The primary problem with the smart people is that they probably know that they are smart. And this intelligence fact is probably coming from an exact science like mathematics, physics, engineering, medicine or the like. The assumptions from exact sciences are not applicable to investing. There is no 2 + 2 = 4 equation here.
Secondly and most importantly one has to respect that in the world of value investing the variables are infinite and thus calculations can show you a bit of the picture but never the whole picture. One has to respect the fact that there is a very large unknown and no one really can analyse all the factors to give accurate predictions of the market.

Thirdly discipline and psychology for the intelligent investor drive returns much more than the analysis. One has to be able to get rid of most of the biases and objectively analyse the situation from a probabilistic standpoint.

That said please don’t stay away from the markets just because you’re smart. This is just a lesson in humility and understanding that the rules of more exact sciences cannot be applied here.