Why are so many people unsuccessful in the investment business? Is it because they lack the intellectual prowess to analyze businesses? Not according to veteran investors like Warren Buffett (Trades, Portfolio), who believes you only need to have slightly above-average intelligence to be successful. What does it come down to then? Well, the most successful investors are those that have a well-defined set of rules they stick to.
What kinds of rules?
Having a systematic approach to investing is very important. Following specific rules and guidelines allows you to control your emotions and reduce the risk of being swept along by the irrational tide.
What rules am I referring to? An example of a very simple rule is Buffett’s idea of a "circle of competence." By forcing yourself to stick to only those areas where you know you have an edge, you increase the chances of stumbling upon a winner, and - more importantly - to reduce the chances you will do something stupid.
There is a reason why ordinarily intelligent and rational individuals end up losing their money in Ponzi schemes, bubbles and just regularly overpriced assets. The lure of seemingly easy money becomes too hard to ignore, and the fact that it lies outside an individual’s circle of competence makes it all the more enticing. By having a hard and fast rule that you never invest in companies that you do not understand, you remove the temptation altogether.
Another rule you might consider adopting is one that states you should never allow any single holding to comprise more than some threshold proportion of your portfolio (10%, 15%, 20%, etc). Whenever a stock is doing well, there is a natural temptation to buy more of it. Now, you may know on an intellectual level that buying more as prices go up is not how a value investor should be going about their business, but on an emotional level, there is undeniably an impulse to do so. Having a rule that limits your exposure is a good way of keeping a lid on such primal urges.
Just animals
As much as we would like to believe we are fundamentally different from other members of the natural world, humans are, at their core, just animals. Indeed, the basic presumption of value investing is markets can be inefficient, and that market participants are very often irrational. Diagnosing this behavior on a society-wide level is easy; recognizing it in oneself is very hard. No one likes to think of themselves as irrational, so we become blind to our own weaknesses. We do not know what we do not know.
This is why rules are important. By having a strong systematic approach that takes decision-making out of your animal brain, you limit the extent to which your own weaknesses can hurt you. They create objectivity, where otherwise subjectivity would freely reign. Far better to accept that you have blind spots, than to be blind to them.
Read more here:
- ”‹Seth Klarman: What Happens When Everyone Suffers From Short-Termism
- Seth Klarman: What Warren Buffett Did During the 1973-1975 Bear Market
- WeWork's Backers Have Had Enough of Its Eccentric Founder
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