In a world where information is readily avaiable in vast amounts, it is hard to separate information from noise, and then useful information from just repetitive information. During a student visit in 2005, Warren Buffett (Trades, Portfolio) got asked if investors are more knowledgeable then than 10 years ago, and this was his response:
"There is no doubt that there are far more 'investment professionals' and way more IQ in the field, as it didn't use to look that promising. Investment data are available more conveniently and faster today. But the behavior of investors will not be more intelligent than in the past, despite all this. How people react will not change – their psychological makeup stays constant. You need to divorce your mind from the crowd. The herd mentality causes all these IQ's to become paralyzed. I don't think investors are now acting more intelligently, despite the intelligence. Smart doesn't always equal rational. To be a successful investor you must divorce yourself from the fears and greed of the people around you, although it is almost impossible.
Do you think Ponzi was crazy? The tech and telecom madness that existed just 6 years ago is right up there with the craziest manias that have ever happened. Huge training in capital management didn't help.
Take Long Term Capital Management. They had 100's of millions of their own money, and had all of that experience. The list included Nobel Prize winners. They probably had the highest IQ of any 100 people working together in the country, yet the place still blew up. It went to zero in a matter of days. How can people who are rich and no longer need more money do such foolish things?"
Here are the main takeaways from Buffett's response:
Quantity does not mean quality: As Buffett mentions, we can get a great degree of information with just a few clicks, but that doesn't translate directly into positive investment results. Munger and Buffett have mentioned previously that knowledge is cumulative, that it works like compound interest. Since there exists a degree of market efficiency and big mispricings are not that frequent, it is only by combining the wide array of gathered knowledge that we are able to recognize when this happens.
Smart is not the same as rational: Buffett and Munger have widely discussed the Long-Term Capital Management case, where some Nobel laureates decided to work together to run a hedge fund. The main takeaway from this point is that being intelligent needs to be combined with a separation from the two main feelings that drive the market: fear and greed. Connecting this to the first point, it is critical not only to recognize opportunities but to act decisively since big opportunities generally stem from panic or extreme optimism. Buffett mentioned that separating from fear and greed is difficult, and it is, since our brain is wired that way. To be able to do so, it is very important to first know ourselves as investors and to train ourselves to overcome our feelings with good rationale.
Irrationality is here to stay: One thing is certain: No matter what happens, the market will never reach full efficiency since it is humans that control it. While the theory of the "rational investor" is appealling, as humans we deal with emotions, and (unluckily) we will struggle to control their violent swings for as long as we live. By adapting a rational framework, however, combined with a vast array of knowledge, we will be able to exploit these swings and use them in our favor.
What do you think?
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