Intuition Is Vastly Overrated
What should we do with our money – is active management better, or should we invest in index funds? Is investment a matter of luck or skill? And what decisions are really important? Michael Mauboussin offers advice.
Simon Brunner: Mr. Mauboussin, are we, as human beings, at all cut out to make good investments?
Michael Mauboussin: Here is the most disheartening statistic in the world of investment: Over the past ten years, the S&P 500 has gone up by 7.7 percent, while the average investor has seen a return of only 5.3 percent. The figures are similar in all of the world's markets. Why is that the case? We often fail to keep a cool head; we buy high and sell low.
Most investors are conscious of this danger, but it is incredibly difficult for them to change their behavior. Why?
We want more of the good and less of the bad. We see that people around us are making a lot of money in the stock market, and we want to be part of that. But markets frequently behave in counterintuitive ways. When they go up, the expected return goes down, and when they fall, the expected return goes up, all things being equal. Another all-too human phenomenon is a desire to be part of the group, which gives us a sense of security. In the context of investments, however, that isn't necessarily a good thing. How did Warren Buffett put it? "You want to be greedy when others are fearful and fearful when others are greedy." It's easy to say, but hard to put into practice.
What does this mean for private investors?
Index funds are a good choice for those who prefer not to spend a lot of time deciding where to put their savings. They represent an entire market or industry, and they are normally broadly diversified. Everyone else can be happy that markets don't always reflect reality, particularly in extreme situations – and such situations provide opportunities for successful investments. Take the first quarter of 2009, for example, when prices were depressed as investors feared the worst.
That's clear in retrospect, but there's an oft-cited stock market rule: "Never try to catch a falling knife."
Of course, it's not enough for prices to be going down, since that might be merely a matter of a price correction. But it was quite apparent in 2009 that certain companies were undervalued. Numerous observers pointed that out – including me.
If I want to actively manage my assets as a private investor, how should I go about it?
If you want to manage your money yourself, I would suggest the following: First, analyze a stock's price. What are the expectations for the future – the likely revenues, operating profits and investment requirements for the coming years?
People want to be part of the group. That is not always a good thing.
And then what?
Second, find out whether the company is likely to do better or worse than expected, strategically and financially. Third, buy or sell. These three steps take a great deal of time and effort. To do this well, you have to be motivated. But the necessary tools are available.
What key figures do you look at when trying to identify stocks with low expectations?
There are several; a low price/book value or price-earnings ratio are good indicators. Historically, such stocks tend to yield a high return, at least over the long term.
When I invest my money, I'm competing with millions of other investors who are thinking in similar terms. So the price of a security reflects the opinion of countless people ...
...Which doesn't mean that they're right!
So I can do better?
Under certain circumstances, yes. But to do better, you have to understand the expectations that are built into the price of a security. Then you can judge whether the market is too optimistic or too pessimistic.
Do you follow your own rules?
I have a broadly diversified portfolio with a number of "cheap" funds, funds with low management fees. I very rarely engage in active trading.
If it's best to invest mainly in index funds and long-term investments, do we really need a bank anymore?
Working with a bank can still be very beneficial for most people: How do you find the right funds? How do you calibrate your diversification? And ultimately, how do you buy and sell? I think most of us – including me – don't have the time or interest to manage a portfolio on a daily basis. Then you have to ask yourself who can help you with that. A trusted banker can be essential in this very sensitive task.
Today anyone can make investments almost as a professional would.
Am I understanding you correctly: Is investing about combating a variety of human impulses that have served us well in the course of evolution? After all, if those impulses weren't beneficial, we wouldn't have them.
Exactly – but they aren't helpful for making investments. Take optimism, for example. Sooner or later, most entrepreneurs give up their business. But they have a fundamentally positive attitude that allows them to put that fact out of their minds – otherwise they'd never start a company, in all likelihood. In the investment world, however, optimism can be dangerous; you mustn't ignore any relevant information. In other words, investing doesn't come naturally to us, and we need to be conscious of that fact. Then we can act appropriately.
Economists say that we as human beings always seek to maximize our self-interest. Are they right?
As a normative theory, this view of humanity is accurate. When looking at how we should behave, it makes sense to look at a specific action's expected benefit.
And in real life?
Our behavior doesn't really correspond to expectations. One example is our aversion to losses. People are roughly twice as fearful of losing money as they are happy about making a profit. This makes sense from an evolutionary perspective. If your food situation is precarious, any further loss of food may have disastrous consequences. But this may not be the right way to look at investments. People hold on to a security too long because they don't want to take a loss, or they sell a profitable stock too quickly. Another example is the "house money effect." People will go into a casino and keep two separate piles of chips, one with the money they brought with them and the other with their winnings or "house money." They continually keep an eye on the money they brought – but keeping the two piles separate provides no advantage in the game. A large pile is better than a small one.
Your most recent book is about luck and skill. Just what is luck?
I like the simple definition best: Skill involves things that are within your control, while luck involves things that are out of your control. Luck can play a larger or smaller role, depending on the specific task. We placed these two concepts on a continuum, with luck at the left and skill at the right. Investing tends to be on the left side.
So investments are a matter of luck?
To a great extent, yes. To understand this, it is important to distinguish between absolute and relative skill. The level of absolute skill is very high when it comes to investments. We have access to considerable computing power and a great deal of information, and we can rely on sophisticated theories of investment. Looking at relative skill, in contrast, it is clear that there is no longer a huge difference between the average investor and the very best. Today, anyone can make investments almost as a professional would. This is called the "paradox of skill." Skill is at a very high level, and it is evenly distributed. In this situation, luck plays an important role.
What does that mean for investments?
Discipline, diversification and a long-term approach are very important for reducing the role of luck.
Nonprofessionals, at least, also point to the role of intuition as a factor that lies somewhere between luck and skill. How important is intuition?
That's a difficult question. My personal view is that intuition is vastly overrated. If you are very familiar with a certain area and that area always behaves in a consistent and linear fashion, then intuition might be helpful. Take chess, for example: Asked to analyze a board, a grandmaster will be able to tell you relatively quickly which player has the advantage and point out a good next move. Grandmasters have analyzed millions of games, the board is always the same size and the pieces always move in the same patterns. If the situation is unstable and non-linear, however – as is usually the case in life – intuition isn't very helpful at all.
But many great ideas have been the result of spontaneous inspiration!
Perhaps someone has actually come up with a 10-billion-dollar idea while taking a shower. But far more people have had an idea while getting dressed in the morning that ultimately went nowhere. Most 10-billion-dollar ideas definitely did not originate in the shower.
Let's talk about sports, your other passion.
You say that luck plays a much more important role in ice hockey than in soccer. Before I explain, let me mention that I'm a big hockey fan, and I also like to play. But hockey players touch the puck much less than soccer players do the ball. And there is less of a gap in the standings between the hockey teams in North America's NHL than between the top clubs in England's Premier League. The NHL, too, is characterized by a "paradox of skill." When it comes to the soccer World Cup, however, the situation is different – there are far fewer matches, and luck plays a more important role.
You've also examined the careers of great tennis players. Is Roger Federer going to win another Grand Slam title?
I believe that Federer is the best tennis player of all time, and the data backs me up. Seventeen Grand Slam titles is an incredible accomplishment, and I doubt that another man will ever be able to match that record, for various reasons. Roger won Wimbledon – a tournament played on a fast surface – after turning 30. All the same, I think it's unlikely that he's going to win another Grand Slam title.
He's 34 years old. The problem with getting older is that your entire system slows down. Your hand-eye coordination, your muscles, and so on. At that level this makes a big difference, especially in tennis, where skill plays a major role. His body is no longer up to it.
That's easy: I do as my wife says.
You're a professional decision maker. How do you make decisions in your day-to-day life? How do you choose a vacation destination, a restaurant, the shirt to put on in the morning?
That's easy: I do as my wife says. All kidding aside, it's incredibly helpful to prioritize decisions based on their possible consequences. At a coffee shop, I don't want to spend hours deciding between a Frappuccino Caramel Cocoa Cluster and a Cotton Candy. I'll order one or the other, and if I don't like it I'll opt for the other one the next time. In the greater scheme of things, even decisions about which car to buy aren't really very important. If you look at it from that perspective, we encounter only a handful of truly important forks in the road over the course of our lives. I'm thinking of marriage or the purchase of a home. I spend a lot of time making those kinds of decisions. For all of the others, my recommendation is this: Don't get caught up in the details.
You have five children. Was that a conscious decision?
Okay, you've caught me there! That was a big decision that we hadn't entirely thought through. We always wanted to have a lot of children, but when it came to the last two or three, my wife was more enthusiastic than I was.
Finally, how much luck have you had in your life?
A great deal. I encountered many people who gave me a lot of support. I had to go through seven interviews to land my first job. Most of the people who interviewed me didn't want to hire me, but then I was able to talk about football with the highest-ranking interviewer. I had noticed that his wastebasket had the logo of his favorite team on it, and made a comment about that. He ended up overruling all of his colleagues.
Is that really luck? Surely you would have done well somewhere else.
In the workplace you need both luck and skill. Probably I would have had a good career in most scenarios, but perhaps it wouldn't have been quite as good.
Where would you place yourself on the luck-skill continuum?
Don't ask – I'm not sure I want to know the answer.