How Emotional Intelligence Can Make You a Better Investor

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IQ versus EQ

vitaly

By Vitaliy Katsenelson CFA

Link: http://www.institutionalinvestor.com/blogarticle/3436914/blog/how-emotional-intelligence-can-make-you-a-better-investor.html#.Vi4-uJWFP5o

Your knee hurts, so you pay a visit to your favorite orthopedist. He smiles, maybe even gives you a hug, and then tells you: “I feel your pain. Really, I do. But I don’t treat left knees, only right ones. I find I am so much better with the right ones. Last time I worked on a left knee, I didn’t do so well.”

Though many professionals — doctors as well as lawyers, architects and engineers — get to choose their specializations, they rarely get to choose the problems they solve. Problems choose them. Investors enjoy the unique luxury of choosing problems that let them maximize the use of not just their IQ but also their EQ — emotional intelligence.

Let’s start with IQ

Our intellectual capacity to analyze problems will vary with the problem in front of us. Just as we breezed through some subjects in college and struggled with others, our ability to understand the current and future dynamics of various companies and industries will fluctuate as well. This is why we buy stocks that fall within our sphere of competence. We tend to stick with ones where our IQ is the highest.

Though we usually think about our capacity to analyze problems as being dependable and stable over time, it isn’t. It might be if we were characters from Star Trek, with complete control over our emotions, like Mr. Spock, or who lacked emotions, like Lieutenant Commander Data. This is where our EQ comes in.

I am not a licensed psychologist, but I have huge experience treating a very difficult patient: me. And what I have found is that emotions have two troublesome effects on me.

First, they distort probabilities; so even if my intellectual capacity to analyze a problem is not impacted, my brain may be solving a distorted problem.

Second, my IQ is not constant, and my ability to process information effectively declines under stress. I either lose the big picture or overlook important details. This dilemma is not unique to me; I’m sure it affects all of us to various degrees.

The higher my EQ with regard to a particular company, the more likely that my IQ will not degrade when things go wrong (or even when they go right). There is a good reason why doctors don’t treat their own children: Their ability to be rational (properly weighing probabilities) may be severely compromised by their emotions.

Example:

A friend of mine who is a terrific investor, and who will remain nameless though his name is George, once told me that he never invests in grocery store stocks because he can’t be rational when he holds them. If we spent some Freudian time with him, we’d probably discover that he had a traumatic childhood event at the grocery store (he may have been caught shoplifting a candy bar when he was eight), or he may have had a bad experience with a grocery stock early in his career. The reason for his problem is irrelevant; what is important is that he has realized that his high IQ will be impaired by his low EQ if he owns grocery stocks.

There is no cure for emotions, but we can dramatically minimize the impact they have on us as investors by adjusting our investment process. First and foremost, investors have the incredible advantage of picking domains where they can remain rational.

For instance, I would not be able to keep a cool head if I owned gold. I can recite the arguments for and against gold (lately, with negative interest rates in certain European countries, the “for” arguments have started to make even more sense). But, intellectually, I cannot reconcile the fact that gold is an asset that generates no cash flows, and thus to me it has no financial center of gravity. I have no idea what it is worth. The very idea of owning gold bothers me, and therefore I know that if I did own it, my EQ would be low. I’d be buying high and selling low.

Now, as a value investor, when I buy a stock and it declines 30 percent, I want to buy more of it (assuming its business has not changed). I wouldn’t trust that I could do this in the gold market.

To be a successful investor, you don’t need Albert Einstein’s IQ (though sometimes I wish I had Spock’s EQ). Warren Buffett undoubtedly has a very high IQ, but even the Oracle of Omaha chooses carefully his battles; for instance, he doesn’t invest in technology stocks.

***

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Our Luxury

Investors have the luxury of investing only in stocks for which both their IQ and EQ are maximized, because there are tens of thousands of stocks out there to choose from, and they need just a few dozen.

Assessment

Meanwhile, I hope when I go see the doctor, he will tell me, “I don’t do left knees,” because the best result will come from a doctor who while treating me will utilize both IQ and EQ.

ABOUT

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.

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Some Behavioral Finance Publications to Review

Conclusion

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OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™

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Written by doctors and healthcare professionals, this textbook should be mandatory reading for all medical school students—highly recommended for both young and veteran physicians—and an eliminating factor for any financial advisor who has not read it.

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http://www.CertifiedMedicalPlanner.org
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3 Responses

  1. Forget Emotions

    The large stock brokers are using Ultra Superfast Computers that are running the stock market to make a profit in milliseconds. People are not involved much with decision making in buying or selling stock anymore.

    Asher

    Like

  2. Maximum Pessimism

    Sir John Templeton, father of international investing, coined the term “points of maximum pessimism” — you want to buy when the news flow is horrible, because the bad news is likely to be more than priced into the stock.

    Dr. D. Marcinko MBA

    Like

  3. “Insanity: doing the same thing over and over again and expecting different results.”
    – Albert Einstein

    Why in the world do investors completely disregard facts?

    Here’s a headline for you written by Amy Whyte on a recent article that appeared at ai-cio.com: “return chasing is rampant among US pensions, endowments, and insurers, the International Monetary Fund has found.”

    At first glance, this doesn’t seem to be a new revelation. Unfortunately, the vast majority of investors have this nasty habit of chasing past performance rather than chasing an investment process. But pensions, endowments, and insurers are supposed to be the smart money that has an infinite time horizon when it comes to asset allocation.

    Yet, the IMF has found that these so-called institutional investors are no different than anyone else when it comes to “rewarding” managers and strategies which have already performed well.

    What is more insane than this is the fact that the evidence is overwhelming that “if past performance is used at all for hiring and firing managers, it is the best performing managers that should be replaced with those who have performed more poorly” as proven in “the Harm of Selecting Funds that Have Recently Outperformed” (Cornell, Hsu, and Nanigan). There findings are not new, as other studies have shown unequivocally that the best strategies to invest in on a going forward basis tend to be those which have performed among the worst over the last few years. Why? Because mean reversion is real, and buying past losers is exactly the definition of buy low, sell high.

    Why in the face of overwhelming evidence that the best time to buy a strategy is when it is out of favor do investors keep falling for the same momentum chasing mentality, rewarding the past rather than giving their portfolio a future with excess returns? Behavioral finance provides answers through the lens of heuristics, but the simplest answer is because investors face tremendous regret. They see some strategy which has performed extremely well, and regret not having gone all-in on that strategy with hindsight. “It’s not too late to buy in” is the mental way of trying to bring back the past and hope for the magnitude of performance to continue.

    Hope, however, is not a strategy. Respecting facts can help yield a successful way of generating long-term wealth. Every strategy, and every cycle has periods of underperformance. Our Beta Rotation Index (click here) had had many periods of underperformance against the S&P 500 over the small sample of a few years, but that has actually ended up being the exact right time to consider allocating to such an approach. Investor insanity prevents that from happening in mass. Instead, investors respond by selling out of strategies in their period of underperformance, and re-allocating to those which have performed the best.

    Yet, factually selling out of winners and buying into losers is how to really outperform in the future. Buying into strategies which are not “working” because of the cycle they had been in completely disrespects the fact that cycles change, and that the future can look absolutely nothing like the past.

    Focus less on performance, and focus less on what’s going up. Focus more on process and mean reversion. That is perhaps the sanest thing anyone can possible do.

    Michael A. Gayed CFA
    [Portfolio Manager]

    Like

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