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Think Like an Investor: Why Rationality Trumps High IQ

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Smartass in Hindsight how to select your next investment2

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:

  • Greed
  • 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:

avoid mistakes and decreasing returns

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?

He continues:

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?

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Comments

  1. Haha notice how the YTcommenter guy even spelled the name wrong. He missed an *a*. True on being a smart-ass in hindsight. It’s easy to say “I told you so” after something has happened.

    Getting the timing right on things is tricky.

    It’s another thing to actually do the thing – I find a lot of people in general like to point fingers, assign blame, or want to seem smart about things like this; things that have already happened and can’t be influenced.

  2. I also read How to Get Rich some time ago and also thought it was weird that he didnt stop working, but I never went deeper into investigating it. Oh well, now I know :)

    That quote from Warren Buffett is solid gold. It makes a ton of sense. Do you know if there’s anyone else who’s written or spoken more about the topic of IQ vs rationality?

    • I also liked that quote. That’s why I put it there :)
      Not sure I know what you mean. . . are you talking about psychology, cognitive biases and such?

      • He’s talking about how you can get rich without a high IQ. He feels insecure about his intelligence.

        Not too worry, mate. Some of the most brilliant people live miserable lives. Base your worth on persistence, grace, and balance.

    • Like Abgrund in the comments on Ludvig’s last article?

    • Yeah I suppose what I mean is what DC/Russ said.

      Hey Abgrund. I read the last article but didn’t read all the comments. However I checked your comments now. Do you believe rationality is more important than IQ? I mean over the course of a lifetime, not just on a standardized test or so.

      • There are more types of intelligence than the type IQ measures.

        Did.you know Henry Ford during a lawsuit was asked to demonstrate that he wasn’t ignorant. The attorney started asking him all kinds of questions until finally Ford got frustrated and said, “have you know that if I sought the answer to any one of these questions I could easily have a fleet of men at my doorstep with their proposed solutions in a matter of a very short time.”

        That kind of intelligence cannot be measured. Like most kinds of intelligence.

        How could a fool orchestrate an entire fleet of wisdom around him?

        Moreover my wife has an extremely high IQ and she’s literally batshit crazy. She can’t tolerate the dysfunction of society to the point of the dysfunction herself. (by the way she’s the one who dictated that last bit, not me)

        What I would guess from your sentence structure and soft words is that you, my friend, have a profound emotional intelligence.

        Use that to your advantage because emotions are Power.

      • If I had to make a one-or-the-other call, I would say that intelligence is most important. To extend the horsepower analogy, nothing in the world will get 100 hp out of a 50 hp motor, and a 400 hp motor used at even modest efficiency will outdo a 100 hp motor which is pushed to the limit. Intelligence is a very powerful “force multiplier”. And there is really nothing you can do to improve it – at best, you can avoid things that might impair your intelligence, like sleep deprivation or drug abuse. Deficiencies in knowledge or rationality can to some extent be made good, if you start early in life.

        That said, most attainments do not require /exceptional/ intelligence. If you want to be successful as a doctor or engineer, you need above average intelligence; a microbiologist or astrophysicist requires greater intelligence still. But a manager, musician, salesman, athlete, or entrepreneur (and many other vocations) can do great with average intelligence. The most important thing in life is not to have /inferior/ intelligence. If you have an IQ of 80, you may be limited to garbage collection, politics, or law enforcement. You also won’t be concerned with theoretical discussions of life, like this one.

      • There is really only one kind of intelligence, the kind measured (although not measured especially well) by I.Q. tests. Intelligence is also sometimes called “g-factor” by psychometrists, because it reflects a /general/ learning ability. It is basically a matter of your brain’s ability to form new connections between neurons. Highly intelligent people learn /most/ things relatively easily; the ability for instance to learn math is highly correlated with the ability to learn new languages and the ability to repair an automobile.

        Some people have distinct aptitudes for certain /types/ of learned skills – music, math, language, or whatever. These aptitudes rarely give a person an advantage that is large compared to their base intelligence, however. An average person with a “gift” for math will still probably be outperformed by a person with 130 I.Q. and no special interest or gift for math, UNTIL the former person has put in more effort learning math than the latter has.

        I think that describing such talents as specialized forms of intelligence is misleading and confuses the meaning of the word “intelligence”. Some people have even gone so far as to describe physical agility as “physical intelligence”. This is ridiculous; we already have words to describe such aptitudes and there is no need to pretend that they are a kind of intelligence, which is a real and quite different thing.

      • Ok. Thank you for the informative answers! You have given me a lot to think of. I would say I am average in my intelligence. And I want to become an entrepreneur in the future when it is a possibility after I have become good enough at some profession I like, that is my current big vision for my career. So it is nice to hear that I don’t need to be the superman many entrepreneurial magazines/websites I read talk about. Sorry I took so long to reply.

  3. Heathenwinds says:

    I like this article. It really hit home with me.

    As a child, I was taught to rely on my high iq. I never really learned to interact on a social level and now I’m having to attain these skills for myself (I’m in HS now)

    That’s not too bad in itself.

    What is bad is my initial reaction to this realization. In 6th/7th grade, when I came to the realization that I was in this state (some doctors thought that I had Autism– no joke!) my initial reaction was to become an egotistic douchebag. Imagine a white, skinny 12 year old who literally couldn’t say hi to a girl walking around with an outsized ego. I had a surplus of intelligence, but no rationality at all. It’s a good thing that all of these mistakes were made in school and not when they could’ve screwed me up big time!

    • “now I’m having to attain these skills for myself (I’m in HS now)”

      –I see. Partying a lot?

      ” It’s a good thing that all of these mistakes were made in school and not when they could’ve screwed me up big time!”

      –That’s a good attitude.

      • Heathenwinds says:

        No. I think that I still suffer from an intolerance of most people. It’s going away though.

      • Yeah I know the pain. It’s really tough to find quality people. But when you do, the partying comes natural.

        I have visions of the future where me and a bunch of other wealthy entrepreneurs get together for a weekend to have “consciousness parties”where people socialize about expanding human consciousness and doing activities that allow each person to delve deeper into their own truths.

        Of course, great music, lots of amazing food, games, sports, laughter, and the finest scotch, wine, and ales.

  4. Ludvig, this is the first time I’ve seen you associate homeostasis with successfully productive behavior patterns (if, perhaps, exhausted ones). So: if you have reached your “sweet spot” where no new dramatic leaps of progress or radical changes of course are desirable, does homeostasis become a good thing?

  5. Good article. I have a couple of remarks:
    * Like everyone else I respect Warren Buffett for what he has achieved, and will never achieve anything like him. Having said that, I am not impressed by his comments (not only here but also elsewhere in the media) when asked about how to achieve & what it takes. He always talks in generalities that you cannot do much with. I understand it because he wants to keep his “system” for himself & his offspring. When he says that one should read a lot, I agree, except that when he says 1000 pages/day I switch off because that is pure b..sh..t.
    His comment about the motor’s horsepower vs its output is a platitude that anyone already knows or can easily work out for himself. But if you were to ask WB how to specifically optimise output (or equalise it with horsepower) you would not get an answer because that would be in part giving away part of the magic WB touch.
    These are just 2 example among a host of others.
    * a company like LTCM was not interested in quality of life, nor are any of its past & modern day peers. Their 1 & only objective is to make as much money as possible for the shareholders/owners. Only private people or companies with high ethics standards are interested (or should be) in quality of life. So I don’t think you can compare a hedgefund-type set-up with individuals.

    • “His comment about the motor’s horsepower vs its output is a platitude that anyone already knows or can easily work out for himself.”

      So you think it’s more important with rationality than high IQ??

    • Astute observations. I think you may be right as far as LTCM goes.

      Regarding Buffett (and Munger), you can learn the fundamentals of their system if you read books like:
      –Poor Charlie’s Almanack
      –Seeking Wisdom
      –The Snowball

      But even if you have the system it will take a long time to practice it until you have it down as an automatic process the way Buffett and Munger do. They’ve taught themselves to think in a very specific way over many many years.

  6. Thanks thus was good to hear because I’m at that sweet spot where align-mentality.com is going to start growing extremely rapidly. For the most part I’ve figured out the secret code.

    My goal is to completely replace my income and I think I can do it in 2015.

    I’ve put a lot of thought into this. When I reach that goal, life will reset. I will be totally free. And when that happens I plan to spend that freed up time with my family.

    This doesn’t mean that I’ll “change direction” so much as I’ll just change my mindset. I will continue to work on align-mentality but my new focus will be gratitude instead of determination.

    It’s really all about your priorities in life. Love, family, camaraderie, and purpose. To me, money is just an enabler to do these things better.

    Thanks for the warnings this article provided. Greed is definitely a very dangerous mentality.

    And also thank you for all of the help you’ve given me. Your insights are profound and your words are powerful.

  7. Hey Ludvig, great article as always.

    I find cognitive biases in the sense you speak of them always take the form of either temptation or fear. I love this analogy I use often, wherein if you were to play the game:

    – Ten coin flips
    – if its ten heads in a row I win 6000 pounds
    – otherwise my opponent wins 1 pound

    Rationally (mathematically) this is in my favour, but most people wouldn’t analyse this rationally. They would take this deal, thinking they are (almost) certain they will win the pound. But really its a cognitive bias of temptation there.

    When I ask them to have such bets officially, they panic, and they decide not to go for it. Now, its fear controlling their game.

    Either way they’re not thinking rationally.

  8. Interesting article Ludvig.

    The sweet spot is hard to maintain because circumstances in life change so unexpectedly and rapidly. If we get ourselves into a nice little routine which produces great results, it’s good for a while, but we always have to be on the lookout for shifting sands.

    Thanks for this! It was food for thought for sure…

  9. Ludvig, I like you for your drive and how you break complicated issues down into pieces.
    But this time you’ve impressed me with your wisdom.
    Strength of character is what we all should work on in the first place. It is handy not only when climbing to the top, but also afterwards.

  10. Interesting stuff, as always Ludvig.

    The story about LCTM & Felix Dennis reminds me of Newton’s 3rd law: Object in motion… .

    I do believe it runs deeper than thinking more logically about changing your direction to increase ROI. I believe Felix identified himself with the winner mentality, he was “the guy who made that amount of money”..

    “We live in a society where we identify ourselves with the things that lie outside of ourselves” – Guy Finley

    Changing direction would’ve meant destroying himself, his identity – does that make sense?

    Having a stable base of internal confidence (based on character) as opposed to an in-stable base of external confidence (based on personality) is what would be the most important aspect in this situation IMO.

    Switching it up is important to remain engaged and satisfied IMO. But what would you do if you have great health, wealth and relationships? (everything you need, basically?) Won’t everything then have a low ROI since all things that provide your life quality have basically been handled?

    For people interested, here’s a list of cognitive biases; http://en.wikipedia.org/wiki/List_of_cognitive_biases

    + What’s your MBTI-type Ludvig (although I know you don’t believe in these tests ;)) I’m guessing INTJ.

    • Hey Simon!

      I agree with you on “internal identity”.

      “But what would you do if you have great health, wealth and relationships? ”

      “Won’t everything then have a low ROI since all things that provide your life quality have basically been handled?”

      –No, everything does not have a low ROI then. ROI isn’t just about money — it’s a totally subjective measure for anything. It’s about life quality, as you say. And your life quality depends on different things — Mazslow’s hierarchy of needs, as I know you’re familiar with. That’s why a lot of wealthy people get into philantropy. It makes them happy at that point.

      I don’t know my Myers Briggs and I don’t care. I looked up the INTJ (scientist stereotype) and I guess it fits. I did some other that, the one you sent me on 7 personalities (can’t remember), and it said I was a visionary. Well. We shall see.

      For anyone reading this — definitely do check out those cognitive biases. Very useful stuff!

  11. Nice series here Ludvig. I think switching to an investor mindset is a key shift every guy needs to make. Having access to OPM or other peoples money is another key one, and that all comes down to sales. When you read about Warren Buffett, he explains that next to Ben Graham, his biggest influence was Dale Carnegie.

  12. Hey Ludvig, love your posts, could you make a /archive page? It’s a bit difficult to find things without it.

  13. This is very interesting. I remember hearing how kids with sky high IQs seldom lived up to their potential. They say what hinders them is often similar to the kind of model you’ve just outlined. They get so good at what’s put in front of them they find it difficult to change, to adapt, or to seek ways to the change the domain they’re operating in. A kind of deep seated commitment bias, I guess.

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