Avoid These 4 Types of Delusional Thinking to Protect Your Investments

Is Intelligence a Handicap in Investing?

Being really smart is mostly a good thing in life. Smart people tend to live longer, earn more, and have a higher quality of life with greater opportunities. A certain level of intelligence is necessary for investing, but it doesn’t guarantee success. Many of the most famous blowups in investing history were products of great minds. Long-term Capital Management had an all-star roster of financial Ph.D.s with lengthy resumes. LTM’s highly leveraged portfolio ended up in collapse, prompting a controversial Federal Reserve bailout.

The intelligentsia is sometimes worse than the Average Joe in critical areas. I’ve seen four types of delusional thinking that can have a substantial negative impact on investing.

We’re going to dive into them today:

1. Overconfidence
The level of overconfidence seems to rise with intelligence. 70% of Americans have above-average intelligence, and 87% of Harvard graduates finished in the top 50% of their high school class. Cross’s work on college professors yielded a stunning 94% feeling that they were above average compared to their ivory-towered brethren. Impressive overconfidence indeed.

2. Confirmation bias
Smart people seem to be better at confirming information than others; however, this can backfire. Instead of using our cognitive abilities to arrive at a logical conclusion, we may use information solely to validate a pre-existing bias that we hold or are emotionally invested in. 

Think of politics. Once someone has an ideology, they will work through all kinds of mental gymnastics to justify their point of view. When confronted with information that challenges their beliefs, clever people often use their intellect to avoid changing their opinions. As they are bright, their arguments can be quite persuasive to both themselves and others.

3. Arrogance
A study by Zagorsky found that individuals with IQs over 140 were more likely to get into financial trouble by maxing out credit cards or filing for bankruptcy. The conclusion is that highly intelligent individuals tend to believe they can solve problems more easily than others. There’s probably some justification for this. Maybe in school, they were able to extricate themselves from difficulties or do well on tests without significant effort.

Arrogance in the financial advisor community is commonplace. I’ve heard some advisors call themselves investment “experts” because they sell securities for an investment firm. If one were indeed an expert, they probably wouldn’t be sitting in front of you. And they wouldn’t need to tell you so. 

I’ve never heard the best investors in the world call themselves experts. In fact, it’s quite the opposite. When confronted with something they know little about, the elite investors take a pass. They are willing to say, “It’s beyond my circle of competence,” which is quite reasonable to admit. 

4. Nobel Disease
Nobel disease refers to scientists who win Nobel prizes and then promote crazy theories with little theoretical evidence. Burton Malkiel authored the Nobel prize-winning book Random Walk on Wall Street. Malkiel told us that security prices reflect all known information; therefore, you can’t beat the market. Malkiel became a big proponent of Efficient Market Theory or EMT. The idea is the stock market is efficient, and stock prices are always correctly priced. Therefore, no one has any advantages, and anyone outperforming the market is an anomaly.

Over the decades, EMT has been resoundingly disproven. Many investors who outperform are products of Columbia Business School’s Investing program. Individuals like Joel Greenblatt, Bill Ackman, David Einhorn, and many smaller and lesser-known investors have audited records going back 30 years of handily beating the market. Malkiel has since downplayed his Nobel-winning thesis and started a hedge fund himself. When asked about his seminal work today, Malkiel downplays its importance, stating, “You know it’s just a theory, right?”

Scientists and award-winning academics alike feel a need to cross-pollinate. Success in one area leads to conclusions in others in which they know very little. To many of us, the shortcoming is obvious, but often, they use their intelligence to back up their faulty view. See #1 above. In fact, the public, you and I, often anoint these people with the halo effect. Instead, maybe you should disregard anything starting with “Nobel prize scientist warns/predicts, states, etc?”

Charlie Munger was once asked about the importance of intelligence in investing. He stated that he would rather have an individual with a 100 IQ who knows his limits and his circle of competence than someone with an IQ of 140. He further suggested leasing the other 40 points to someone else and using only the 100 for investing.

Everyone wants their affairs handled by someone who is smart and clever. But this could be a mistake. We all would be better off choosing wisdom over intelligence. Your investment manager should possess humility, curiosity, self-awareness, and open-mindedness. They should accept that uncertainty is a given in life. And if they are also intelligent, even better.