I was watching a video on YouTube of Warren Buffet giving a speech and I saw this comment.
It made me snicker.
Yes. It’s easy to be a smart-ass in hindsight.
But it’s hard to be smart — and put your resources where your mouth is — when it actually matters.
In the last part I told you about the hedge fund with the ironic name, Long-Term Capital Management (LTCM), and how they suddenly went bankrupt by taking unnecessary risk. . .
Unnecessary as in risking what they needed to get what they did NOT need.
But again, it’s easy to be smart in hindsight.
Put yourself in their shoes: you’ve got two Nobel Prize winners and some of the smartest and most successful people in the financial industry. Confidence must be sky-high. And why shouldn’t it be?
–They had made a killing for three years straight. They were expecting business as usual.
Only it didn’t go that way — and they lost everything they had.
Why did they take such a foolishly large amount of risk?
Because their brains got warped by cognitive biases.
Despite the fact that they were all incredibly intellectually intelligent with high IQ, they still made obvious mistakes in their decision-making. Certain psychological influences turned their brains to mush.
In one of Warren Buffett’s speeches (not the one I got the image above from) he gives an illustrating explanation of this:
I always look at IQ and talent as representing the horsepower of the motor. But then in terms of output — the efficiency with which the motor works — that depends on rationality. Because a lot of people start out with 400 horsepower motors and get 100 horsepower of output. But it’s way better to have a 200 horsepower motor and get it all into output.
The leadership of LTCM probably had 400 horsepower motors, but how much was converted to output?
Their high IQ did not protect them from being negatively influenced by psychological factors such as:
- Group think
- Commitment bias
- Assuming the future would be similar to the past (and that their money-making strategy would keep working)
- False sense of security due to overconfidence, which caused them to underestimate the risk
And mistakes like these don’t just happen in finance.
They happen EVERYWHERE.
But LTCM actually made another mistake, other than risking what they needed for what they did NOT need. What am I talking about?
It’s that they also made a terrible decision in terms of. . .
. . . Life quality.
The potential loss of ruining their reputations and losing their clients’ money FAR outweigh the potential gain in life quality by earning a bit more money.
Let me explain.
You Should Focus on High ROI-Activities (Important Stuff)
When you set a goal you want to figure out your ideal situation. What is the best-case scenario for what you’re working on?
You know, the sweet spot where you don’t have much more to gain — in terms of life quality and improving your life — from taking extra risk and putting in more time, money or effort into the thing.
When you get to that sweet spot you want to stay there by playing the loser’s game (avoiding mistakes and unnecessary risks).
Then you shift your time and focus to improving some other area of your life where there is a higher return on investment (ROI).
Here’s how it works in theory:
Because it does not make sense to take risks or spend lots of time and effort on something that is not going to improve your life in proportion to the work you put in.
And that’s exactly where you’re at once you reach a point of decreasing returns to scale.
What the guys at LTCM did does not make sense, logically speaking.
Only they weren’t thinking logically.
And they’re far from being the only rich and high IQ people to lose track of what matters and forget to maximize life quality.
In his autobiography, How to Get Rich, billionaire Felix Dennis writes how he screwed up in a similar way:
Like an old, punch-drunk boxer, I couldn’t quit. I always craved just one more massive payday. One more appearance under the lights with the roar of the crowd and the stink of the sawdust and leather. One more fight. “I can take this young punk. I know I can. Just this once, so I can go out as a winner. So I can retire as the champ. Then I’ll retire. Just this last one.”
Sounds to me like a combination of greed , commitment bias and the winner effect. What do you think?
Up to just seven years ago I was still working twelve to sixteen hours a day making money. With hundreds of millions of dollars in assets I just could not let go. Like I said, it was pathetic. Because whoever dies with the most toys doesn’t win. Real winners are people who know their limits and respect them.
[Interesting aside: I actually tried getting in touch with Felix Dennis after I read his book. But I wasn’t successful. Now that I look him up on Wikipedia, I see that he died (from throat cancer) just a few weeks after I made contact. No wonder I never got a reply.]
In Felix Dennis’s case, the ROI — in terms of life quality — isn’t maximized by earning more money. He
says said it himself. He should’ve quit earlier and spent his time focusing on poetry instead, which was his biggest hobby.
How to Choose Your Next “Investment”
Here’s how I see it:
First you set a big goal and do the planning (as you go).
Then you do the things you need to do to reach your goals.
And then you do those things some more (because nothing good comes easy).
You put in the time, the effort and you do the work.
As a result of this you get yourself addicted to these activities so that they become your “passion”.
You go through trial and error and learn from the mistakes you cannot avoid.
Then you reach your goal (maybe you make a pile of money?).
Finally, once you’ve reached your destination, your ideal scenario, you need the clarity of mind and the strength of character to:
- Maintain your sweet spot position
- Or quit what you’re doing and change direction
But it won’t be easy — because you have so much momentum going for you to continue in this direction (homeostasis wants to remain intact).
To change what you’re doing, and starting to invest into another area of your life, with a higher ROI, will be a challenge–psychologically and biologically. Homeostasis challenges you, hinders you–puts up a resistance–from thinking logically about it.
And as Warren Buffett says. . .
. . . Even if you have a strong motor it doesn’t matter unless you can get it to function at maximum output.
Even if you have all the IQ in the world it doesn’t matter unless you can remain rational and accurately evaluate the situation.
Therefore changing direction is hard and takes a lot of energy.
Especially when you’ve committed a lot to the process.
Both mentally and physically speaking.
That’s why Felix was addicted to working and didn’t want to stop, despite the fact that he logically knew he didn’t have much to gain in terms of increased life quality.
That’s why those high-IQ guys at LTCM didn’t want to stop either. They liked the direction they were headed so much that they didn’t mind driving off the road.
Do you have what it takes to change direction?