EQ And Not IQ Is The Key To Investment Success…

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We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

—John Maynard Keynes (1964, 162–63)

I am not a big fan of watching mainstream financial media except for its sheer entertainment value. The other day, I turned on CNBC and happen to watch Jim Cramer do his usual antics. Just as I was watching, I started to think that so many people could be watching him and others like him and probably acting on that information, trusting fully the “expert insights” he and others like him dish out on a regular basis. The financial “porn” depicted in these media outlets is at most times successful in instilling fear or greed in investors psyche, inciting them to do exactly what will hurt them in the long run.

Now don’t get me wrong. These financial media personalities are all smart people and probably have high Intelligence Quotients (IQs).  But is that a requirement for success in investing. Researchers in behavioral finance in various studies have concluded that successful investing requires a heavy dosage of emotional intelligence or what they have come to quantify as Emotional Quotient (EQ).

Emotionally stable people accept the fact that they don’t know everything and consider it a futile exercise in trying to become a know it all by spending every waking hour, digging through as much information as possible. This allows people with high EQ to reach financial independence far sooner and with a lot less stress in their lives not because of how much they know but ironically by conceding how much they don’t.

To most investors, this is wildly counterintuitive. After all, we know there is a high correlation between education and income. The average graduate, for example, makes almost 70% more per year than the workers with just a high school diploma. So when it comes to investing, it’s natural to assume that the smartest and the most read investors are the most successful.

That’s not necessarily true. Experience shows that more often, it’s humility – not superior knowledge – that leads to success in the world of investing.

Twice a year, the Wall Street Journal polls 55 of the nation’s top economists to see what lies ahead for the economy, interest rates, the dollar and other economic variables. Most of them get it wrong. Their consensus isn’t so hot, either. It’s gotten to the point where even the WSJ staff is having a chuckle. Reporter Jesse Eisinger in one of his columns writes, “Pity the poor Wall Street economist. Big staffs, sophisticated models, reams of historical data, degrees from Ivy League schools and still they forecast about as well as groundhogs”.

Albert Einstein, for example, is considered the universal symbol of genius. He discovered the theory of relativity, won the Nobel Prize in physics, and made scientific advances in gravity, cosmology, radiation, theoretical physics, statistical mechanics, quantum theory and unified field theory. Wouldn’t an investor be blessed to have an IQ like his?

Perhaps not. Einstein lost his investment capital – including his Nobel Prize money – on bonds that defaulted. For all his genius, he was a failure at investing.

Or take Long Term Capital Management (LTCM). LTCM was a hedge fund created in 1994 with the help of two Nobel Prize winning economists. The fund incorporated a complex mathematical model designed to profit from inefficiencies in world bond prices. The brilliant folks in charge of the fund used a statistical model that they believed eliminated risk from the investment process. And if you’ve eliminated risk, why not bet big?

So they did, accumulating positions totaling $1.25 trillion. Of course, they hadn’t really eliminated risk. And when Russia defaulted on its sovereign debt in 1998, the fund blew up. LTCM shareholders lost their shirts in less than 4 months. To clean up the resulting mess, Federal Reserve Chairman Alan Greenspan had to orchestrate a buyout by 14 investment banks.

Another example is Mensa. This society welcomes people from all walks of life, provided their IQ is in the top 2% of the population. But these folks could stand to pick up a copy of Investing for Dummies. During a recent 15 year periods when market in general averaged 15.3%, the Mensa Investment Club’s performance averaged returns of just 2.5%. That isn’t just lagging performance. It’s more like getting left on the station platform. As Warren Buffett once said, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ”.

History also suggests that if your portfolio is run by a market timer – someone who plans to have you invested during market rallies and out during the sell-offs – you are wasting both your time and your money. Unfortunately, time and money are exactly the two ingredients required to reach financial independence. You cannot afford to waste either.

Consciously or unconsciously, investors imagine that the investment process works something like this – “First you make an educated guess about what the economy is likely to do. Based on this, you have a hunch about where the market is likely to go. And based on that, you have a theory about what sorts of investments you should be buying”.  Do you want to invest your hard earned savings using a theory that’s based on a hunch, that’s based on a guess?

Even with all this data, investors continuously look for that magic elixir, that sage who could be their broker, money manager, newsletter editor or a television pundit who can tell them what the future holds.

So if all these investing smarts do not work, how do you achieve financial independence? You start by facing facts – by using a system that doesn’t rely on guesses about the economy and the markets and by knowing what you don’t know. Investment success comes from understanding basic investment principles, putting them to work in an effective strategy and applying a bit of discipline. The idea is straightforward but completely alien to most people. They figure that the best investors have uncanny insights about what’s in store for the economy, interest rates, the dollar, and the stock market.

A firm belief in Albert Einstein’s aptly quoted phrase “Everything should be made as simple as possible, but not simpler” will take you a long way in your family’s journey to financial independence.  A simple investment plan still needs to adhere to tried and true principles of portfolio construction with the right investment mix and asset classes, with regular re-balancing and attention to minimizing taxes and expenses. You do that consistently over 10, 20 and 30 years and you are almost guaranteed to reach your financial goals.

So coming back to all that noise in the media outlets, enjoy it but don’t stress it. And make sure your IQ does not overpower your EQ.

Happy Investing.

Image credit – Ly Thien, Flickr