Wednesday, March 3, 2010

Emotionial Intelligence Will Wreck Your Portfolio

We all want to be liked. We want to be part of the crowd. And we want to be where the action is.

When our team is playing for the championship we want to be in the stands cheering. When it is about to suffer ignominious defeat we adopt the same sulking posture as our friends and neighbors.

We are so afraid of being cast aside that we do our best to think as everyone else thinks and to feel as everyone else feels. Often, when we make investment decisions we are more interested in being attuned to the mood of the crowd than in making money.

We have learned all this in our sensitivity training workshops. We want to develop our emotional intelligence and our capacity for empathy. We have made a fetish of fellow-feeling. We are convinced that it is the key to worldly success.

Of course, there is more than one way to get along. Following your heart is not the same as following the rules of etiquette. Besides, too much empathy will make you an inferior competitor; you cannot compete successfully if you are sensitive to the feelings your opponent will have when you defeat him.

If you want to succeed in business, I recommend insensitivity training. Link here.

Now we learn that insensitivity training might also make you a better investor. If emotional intelligence attunes you to the moods of others it can only wreck your portfolio.

As everyone knows, you make more money going against the crowd than you do in following it. The principle of contrary investing says that you should buy when everyone wants to sell and sell when everyone wants to buy.

When everyone believes that it cannot go down, you should sell. When everyone thinks that it cannot go up, you should buy.

To do that well, you need insensitivity training.

Everyone believes in contrarian investing. Yet, the principle is, as Shakespeare had it: "more honored in the breach than the observance." Why is it so hard to be a contrarian investor; why is it so emotionally taxing?

Tadas Viskanta, proprietor of the investing blog, Abnormal Returns, asked precisely that question in a post yesterday. Link here.

Like many of us Viskanta was reading the just-published chapter from Michael Lewis' new book on the financial crisis. Link here.

But like few of us, he was struck that the first man who figured out how to make a fortune by shorting sub-prime mortgages, a man named Michael Burry, was far from being the most emotionally intelligent human on the planet. In fact, Burry was suffering from Asperger's Syndrome.

Asperger's is akin to autism. People who suffer it have some of the same traits as autism, but are generally more functional. They tend, as Viskanta says, to become obsessed with trivial details and data. They are also notoriously incapable of tuning in to other people's emotional states.

Asperger's, as Lewis says, causes people to fixate on abstractions. It could be numbers, it could be games, it could be puzzles, it could be "lawnmower catalogues." People with this condition can focus and concentrate for endless periods of time on minute, trivial, irrelevant details of things like sub-prime mortgages.

As Lewis put it, Burry was lucky that he was drawn to subprime mortgages. He might just as easily have been fascinated by "lawnmower catalogues."

Besides this love of trivial detail, Burry had another great advantage as an investor. As Viskanta puts it: "One could argue that having some diminished capacity to read the emotions of others may in fact be valuable in success as a contrary investor."

As I said, this is easier said than done. And not just because most of us do not emulate people with Asperger's.

Speaking about the emotional difficulty of holding short positions in sub-prime mortgages, Viskanta writes: "To hold that sort of position, like shorting subprime mortgages when everyone thinks the value of real estate can't go down, is an emotionally taxing proposition. You are constantly being bombarded by news and opinion that you are in fact wrong. However, for those individuals who are less able to read emotional cues this investment process may come more easily."

If you want to test your own emotional insensitivity, ask yourself this. When everyone in your neighborhood is going to get together to celebrate a victory or to greet the dawn of a brighter tomorrow, are you emotionally equipped not to attend and not to care? Would you rather join the party or read the prospectus for a bond offering?

Or, ask yourself this: when all of your friends are losing money, does that make it easier to lose money yourself? Would you rather be able to commiserate with your friends, by being in the same situation, thus being one of the gang, or would you prefer to have to shut up and dissimulate the fact that you have been making money while they have been losing theirs?

How many people hold on to losing positions because they want to be just like everyone else?

In either case, if you go against crowd sentiment, you will be consigning yourself to strangeness, weirdness, and the status of an outsider.

This will tax your emotions and drain your energy. If you think that it is easy and that you just need to follow a couple of sentiment indicators, you have missed the point.

If you are not willing to work as hard as your competitors, if you are not obsessed with detail, then you would do best not, as Viskanta suggests, to step into the arena with them.

If an investor's emotions are his enemy, then he should develop a system, and follow the most strict discipline in making his decisions. Never make decisions on whim, but never, never, make them because you want to own the same stock that everyone owns. Especially when everyone is convinced that that stock can never go down.

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