On Investing: The many hats of great investors

On Investing: The many hats of great investors
The Washington Post, on May 21, 2011

Graduation season is upon us. From the next generation of Warren Buffett wannabes, I occasionally hear questions such as “What should I learn to become a great investor?”

Contrary to popular belief, investing isn’t a traditional academic discipline. Money management is hardly a typical major. There are, of course, plenty of “Business Administration” undergrads, but their focus tends to be on running companies, rather than investing in them.

We churn out MBAs like made-in-China widgets, yet few ever become outstanding investors. And don’t even ask about economists — the profession that missed the housing boom and bust, the Great Recession, the credit crisis and the market collapse.

Great investors are savvy generalists. I can think of five fields that are hugely helpful to asset management. If you were to study these disciplines, your understanding of how markets work would greatly improve. And you would be a better investor.

How? You will generate better risk-adjusted returns; meaning, you will get the most bang for the bucks you are putting at risk. You will suffer less from volatility — the stomach-churning ups and downs in the markets that are one part risk, one part opportunity. And you will avoid the typical mistakes that most investors make.

The five disciplines that can help:

Historian: Knowing what has happened in the past (and how often) is an enormous advantage when it comes to investing. It informs you of the range of possibilities, allows you to conceptualize possible outcomes to various scenarios and provides a framework for thinking about market cycles.

Heading into the market bottom in 2003, some market historians warned about a secular bear market. These are the decade-plus long periods of huge rallies and great collapses. Some warned that investors should not be surprised if after a decade, the markets were essentially unchanged, which is exactly what happened.

Think back to the market lows in March 2009. After about a 20 percent bounce off the bottom, quite a few commentators expressed fears that the markets had gone “too far, too fast.” Market historians knew that the median bounce after a drop of 50 percent or more was 75 percent. With that information, you might not have been scared away from equities just before they gained 80 percent in value over 18 months.

Psychiatrist: Speaking of scared: Have you ever sold anything in a panic — then regretted it over the ensuing months? What about the opposite — greedily buying stocks that were screaming higher because everyone else was?

Many investors fall prey to these errors. Fear and greed are the most enduring investor emotions. They lead to destructive behaviors. Carl Richards, a financial planner, sums it up thusly: “Buy greed at tops; Sell fear at bottoms; repeat until broke.”

Not understanding your own psychology is the downfall of many an investor. The best financial plan becomes worthless if you are unprepared for the emotional turmoil that accompanies the ups and downs of markets.

The crowd becomes an unthinking mob at tops and bottoms. Being able to read the emotional state of the market, as well as keeping your own emotions in check, are hallmarks of great investors.

Trial lawyer: Good litigators are always skeptical, but not negative. Is that witness telling the truth? What is motivating him? Is the opposing counsel’s argument logical? Being able to answer these questions makes for a good lawyer – and a good investor.

All CEOs want you to buy their company’s stock; every analyst wants you to follow his equity calls; every fund manager wants to run your money. When it comes to investing, everyone is trying to separate you from your money. Good investing requires good judgment. Being able to recognize valuable intel versus the usual blather is a huge advantage.

Like a good litigator, you must question data, consider alternative explanations, argue against the obvious. You cannot blindly accept everything you hear as truth, nor can you reject everything out of hand. Being able to discern between information that is valuable and that which is not, is crucial.

Mathematician/statistician: Investing is filled with math: compound interest-rates, dividend yields, long-term gains, price-to-earnings ratio, risk-adjusted returns, percentage draw downs, annualized rate of returns.

Don’t worry if you suffer from math anxiety: If you can operate the simplest calculator — even the free one that came with your computer — you have the requisite math skills needed.

If you follow the professional literature there is a plethora of advanced mathematical formulas of dubious utility. Value-at-risk is a complex mathematical formula that was supposed to tell Wall Street banks how much risk they could safely assume. It failed to prevent them from blowing themselves up during the credit crisis. The Sharpe ratio measures the excess return — the “risk premium” — an investment strategy has. Even William Sharpe, its creator, has said it’s been misapplied by Wall Street’s wizards.

Investors can ignore these sorts of mathematical esoterics. But understanding basic math is key.

Accountant: When you buy a stock, you are buying an interest in a company’s future revenue and profit. How much you pay for that future cash flow determines whether you are over or under paying. That means understanding the basics of a company’s books is a key to recognizing value.

An understanding of basic accounting is essential to grasping the fundamental health of a company or business model. It is how you determine whether an existing company is profitable, or when a young firm might become profitable. But it also can help you determine when a formerly profitable company is heading down the wrong path.

You don’t have to be a forensic accountant. These are sleuths in green visors poring over pages and pages of quarterly filings and footnotes, looking for evidence of fraud or accounting shenanigans. Forensic accountants are the guys who discovered the frauds at Enron and Worldcom, and they warned about AIG and Lehman Brothers.

Amazingly, even after these frauds were revealed, many investors refused to believe them. Having a basic knowledge about accounting can help you understand and heed the work of forensic accountants.

You don’t need to have an MBA or doctorate in economics to be a good investor. Indeed, as the spectacular blow up at Long-Term Capital Management has taught us, these can be impediments to good investing.

Instead, you need to develop more general skills. Learn market history, understand crowd psychology, how to think critically, be able to do simple math and understand basic accounting. Do this, and you are on the path to becoming a much better investor.

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Ritholtz is chief executive of FusionIQ, a quantitative research firm. He runs a finance blog, The Big Picture.

On Investing: The many hats of great investors