Think the best investors are the smartest investors? Think again. In 1998, Long Term Capital Management, a hedge fund created in 1994 with the help of two Nobel Prize winning economists, blew up.
The geniuses 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 large?
So they did, accumulating positions totaling $1.25 trillion. Big mistake. The fund's investors lost billions. To clean up the resulting mess, Federal Reserve Chairman Alan Greenspan had to orchestrate a buyout by 14 major investment banks.
If only this were an isolated example. . .
Mensa is a society that welcomes people from all lifestyles, provided their IQ is in the top 2% of the population. Unfortunately, these folks could stand to pick up a copy of Investing for Dummies. During a recent 15-year period when the S&P 500 had average annual returns of 15.3%, the Mensa Investment Club's performance averaged returns of just 2.5% per cent.
That isn't just lagging performance. It's more like getting left on the station platform.
Use your 'EQ,' not your IQ
It turns out Daniel Goleman was right. In the 90s, he was the guy promoting the notion that success is more closely tied to emotional intelligence than education or knowledge.
In his book Emotional Intelligence, he writes, "As we all know from experience, when it comes to shaping our decisions and our actions, feeling counts every bit as much -- and often more -- than thought. . . Passions overwhelm reason time and again."
Goleman argues that two key aspects of emotional intelligence are impulse control and persistence. And these are exactly the two qualities that will keep you from abandoning your investment strategy in a panic.
Take the last four months, as an example. The market began a meltdown in early August when it became apparent that rising defaults in the subprime market were creating a liquidity crisis in world credit markets. As stocks sunk lower, many investors feared the worst and bailed out.
Then the Fed began cutting rates aggressively and the market rebounded smartly. Investors began to feel optimistic again and piled back in. The market promptly went back into the tank. Many of the same Nervous Nellies sold out again in mid-November. Only to see the Dow soar nearly 700 points over the next three weeks.
Don't look for logical explanations of what's going on here. It's not rational behavior that causes these dramatic short-term swings. It's fear and greed, plain and simple. And, as we're still in the early innings of this credit crunch, the volatility is likely to be with us awhile.
What does this mean for you as an investor? It means you need to use your EQ, not your IQ:
1. Do a reality check. Recognize that investing in stocks means your account value is bound to sustain wide fluctuations from time to time. It's unrealistic to think you're going to earn the superior returns only stocks can give while watching your brokerage account rise as steadily as a savings account.
2. Automate your investments. If you're in the early stages of wealth accumulation, use a discipline like dollar-cost averaging -- investing a consistent amount at regular intervals -- to take advantage of the market's occasional swoons.
3. Follow a trading discipline that negates emotional decision-making. Trailing stops, for example, don't feel fear, greed, hope, envy, pride or jealousy.
4. Resist the urge to 'do something.' It's one thing to feel fearful about the market. It's quite another to let that fear trump your well-laid investment plans.
Studies in behavioral finance clearly demonstrate that it's not your store of market knowledge that is most likely to determine your success as an investor. It's whether or not you let your emotions dictate your actions.
I'm not saying you shouldn't feel emotional from time to time. After all, we're only human. But it's safe to say that if you let those emotions control your investment decisions, eventually you're going to feel something entirely different. . .
Alexander Green is the Chairman of Investment U and Investment Director of The Oxford Club.
Courtesy: www.investmentu.com
