Almost every investor likely wishes they were more intelligent. They may feel this could make a significant impact on their investment returns by allowing them to more fully understand a wide range of stocks and sectors. Moreover, they may believe greater intelligence could aid them in successfully valuing companies in order to ascertain their intrinsic value.
Intelligence versus temperament
However, intelligence and successful investing may not be as closely linked as some investors believe. After all, almost every investor is likely to have the mental capacity to understand specific sectors, so they can build detailed knowledge of them.
Furthermore, being able to understand complex formulas or equations may be unnecessary when valuing a stock. Simpler valuation metrics, such as price-earnings or a basic discounted cash flow calculation, may sufficiently indicate a company’s intrinsic value.
Conversely, an investor’s temperament may be of great importance when apportioning capital. For instance, an ability to avoid excessive optimism when stock prices are high during a bull market may help to avoid overvalued shares. Likewise, an ability to look beyond extremely challenging periods for the economy may allow an investor to purchase high-quality stocks while they trade at low prices during a bear market.
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Chairman Warren Buffett (Trades, Portfolio) has previously commented on the importance of temperament relative to intelligence. He said, “The most important quality for an investor is temperament, not intellect.”
Clearly, Buffett is extremely intelligent. However, it could be argued that his ability to remain level-headed throughout any market conditions is his biggest strength. He has continually capitalized on temporary challenges facing companies or the wider stock market to purchase high-quality businesses while they traded at low prices. Similarly, he has consistently avoided the euphoria often felt by his peers during bull markets that led them to overpay for stocks.
A learned behavior?
Judging by Buffett’s long track record of investment success and his modest lifestyle, self-discipline is part of his character. However, not all investors are as fortunate in this regard. Indeed, it is relatively commonplace for emotions to cloud an investor’s capacity to allocate capital during extreme stock market conditions.
In my view, all investors could benefit from creating specific "rules of engagement" that dictate under what circumstances they will buy or sell shares. For example, this could be something simple such as a rule that requires a specific discount to a company’s intrinsic value to be met to warrant purchase. Or it could mean they only hold stocks that have achieved a minimum level of return on invested capital over a five or 10-year period.
This strategy may help to counter the natural urge for investors to factor in emotions when managing their portfolio. Implementing such a plan may never lead to self-discipline on the scale enjoyed by Buffett, but it could make a far bigger impact on long-term returns than having a greater amount of intelligence.
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