When there is a crisis, that’s when some are interested in getting out and that’s when we are interested in getting in. – Carlos Slim Helu, currently the second richest person in the world.
I happened to be in a bookstore one time and I saw a book entitled Why Smart People Make Big Money Mistakes. . .
It kept me thinking. I already lost big money. Am I smart then? Hmmm.
All along I thought there’s only one kind of intelligence and that’s the one which is exclusively found in the four corners of the classroom.
Until I read Robert Kiyosaki’s financial intelligence in his bestselling book Rich Dad Poor Dad and Daniel Goleman’s Emotional Intelligence. They opened my eyes.
Here are my thoughts on both intelligences in the stock market arena. Mind you, being smart and being composed are two different realms.
I was aspiring to be a CFA (Chartered Financial Analyst) before. I thought this could sharpen my mind in selecting stocks, and for career advancement as well.
CFAs are well-respected by many. They are considered experts in finance, just like theologians in Christianity. They undergo rigorous studies.
But when I saw its syllabus and the tuition I have to pay, I said thanks, but no thanks. It’s not worth it.
I thought I better read all books that I see in bookstores, and in the internet, about Warren Buffett. I better have a personal study on how a billionaire does it, which is not even a subject in CFA.
Warren himself recommends a book which he admits influenced him a lot. It’s The Intelligent Investor authored by his mentor Benjamin Graham himself. If you are not a hard-core reader, he suggests chapters 8 and 20 for you.
Plus, I read a research revealing that many CFAs today ignore Graham’s teachings. Many of them base their buy recommendations on recent prices of stocks than on the long-term outlook of businesses.
And that’s not how Warren Buffett does it. How then a smart investor like Warren filter great businesses from the average ones?
I discovered two general criteria which I found in the many books I read about Warren and other renowned value investors.
First, look for businesses which generate a lot of cash. In the Statement of Cash Flow, see if the ‘Net cash provided by operating activities’ is consistently positive and increasing.
Second, compute Return on Equity (ROE). Warren repeatedly mentions this in his annual letter to Berkshire’s shareholders. It tells how the company’s managers utilize shareholders’ resources to generate profits. The higher the ROE, the better.
The above is easy; you can just read books. This is the hard part here. What makes this hard is the fact that when it comes to money, many go nuts.
A person with PhD won’t necessarily make money. Even a scientist. That’s what happened to Sir Isaac Newton. A smart guy. In fact very smart. But he lost money in the stock market.
So, as to the question ‘why do many smart people make foolish financial choices in the stock market?’
Emotion. It’s when emotion overwhelms reason (not only in the stock market I think). Many smart guys just can’t manage their emotions. They panic when they see red, and get too excited when they see green.
Further, instead of thinking independently, they follow the crowd. When market nosedives they also want to sell like the rest in the market; when the market skyrockets they also want to buy just like what the rest are doing.
This is called irrational behavior. Though many investors proudly admits they are smart, they however behave stupidly most of the time, which costs them money.
How do we win then this losers’ game?
Have the backbone to buy when the market spirals down. Have the guts to sell when the market is overvalued. Amidst the whirlwinds in the market, stay calm and be a contrarian. That’s emotional intelligence.
Warren even suggests to stay calm and hold your stocks of greats businesses for long.
Absent these characters, you won’t do well in the market over the long haul.
Be reminded also of what John Templeton, another successful investor, proclaims:
The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.