By Robert Scannell, MBA, JD, CFA®
Oscar Levant, a well-known musician and Hollywood celebrity in the 1950’s, famously remarked that while “there is a fine line between genius and madness, I have erased this line.” His hilarious observation points out something that most of us already know, which is that sometimes brilliance is accompanied by a diverse basket of psychological demons. It turns out this is as true in the investment world as anywhere else, and it has critical implications for your portfolio.
The line between investing genius and investing madness is especially important because successful investors generally take one of two paths: they invest with the crowd (momentum investors) or they invest contrary to the crowd (value investors). Although both approaches have merit, they have very different psychological implications.
The momentum investor spends his day “surfing” the market, basking in the knowledge that his views are shared by thousands of other investors. Although a brief look at investment history shows us that the “crowd” is sometimes very wrong (Read Extraordinary Popular Delusions and the Madness of Crowds.) in the short-term, momentum investors take comfort in knowing that, at least for now, many others share their view.
The moral of the story is that for the value investor, managing your own psychology is as important (or perhaps more important) than managing your investment portfolio.
In contrast to this psychological comfort, the value investor lives in a stark psychological desert. He is taking a position contrary to the crowd, and is implicitly saying to the market “I’m right and you are wrong!” Taking such a position comes with a minefield of self-doubt. “Who am I to second-guess the market?” “Why doesn’t the market see what I see?” “If this situation is so interesting, why hasn’t someone already taken advantage of it?” The passage of time only makes the psychological pain worse. “Why aren’t others seeing what I’m seeing?” “Was I arrogant to second guess the market?” “Have I lost my mind?”
The moral of the story is that for the value investor, managing your own psychology is as important (or perhaps more important) than managing your investment portfolio. Here are a few suggestions that might help you keep track of the line between investment genius and madness.
First, diversification is critical in value investing. Some of your positions will ripen quickly, some will ripen slowly, and some will be stillborn. Diversification and appropriate expectations will make the inevitable losers easier on the psyche. Second, become better educated about your niche. This does not mean getting a PhD, but it does mean being a full-time learner, especially in your area of expertise or interest. Domain expertise will give you the confidence to periodically take a stand against the market. Finally, be a student of financial market history. Perhaps more so than in any other endeavor, history repeats itself in the investment world. There are endless examples of the “crowd” getting it tragically wrong, and this knowledge can help you weather tough psychological headwinds.
Finally, stay humble. Even if you are a legitimate investing genius, a comeuppance may be right around the corner (Read When Genius Failed … which describes the collapse of Long-Term Capital Management.). As Oscar Levant may have known, hubris is the ingredient that blurs the line between genius and madness.