William Bernstein has an eclectic background and is well-known in the world of finance. He’s done a lot of thinking about asset allocation and runs the Efficient Frontier website as well. An excerpt from the foreword of his new book has a discussion of the qualities it takes to manage money well. The emphasis is mine.
Successful investors need four abilities. First, they must possess an interest in the process. It is no different from carpentry, gardening, or parenting. If money management is not enjoyable, then a lousy job inevitably results, and, unfortunately, most people enjoy finance about as much as they do root canal work.
Second, investors need more than a bit of math horsepower, far beyond simple arithmetic and algebra, or even the ability to manipulate a spreadsheet. Mastering the basics of investment theory requires an understanding of the laws of probability and a working knowledge of statistics. Sadly, as one financial columnist explained to me more than a decade ago, fractions are a stretch for 90 percent of the population.
Third, investors need a firm grasp of financial history, from the South Sea Bubble to the Great Depression. Alas, as we shall soon see, this is something that even professionals have real trouble with.
Even if investors possess all three of these abilities, it will all be for naught if they do not have a fourth one: the emotional discipline to execute their planned strategy faithfully, come hell, high water, or the apparent end of capitalism as we know it. “ Stay the course ” : It sounds so easy when uttered at high tide. Unfortunately, when the water recedes, it is not. I expect no more than 10 percent of the population passes muster on each of the above counts. This suggests that as few as one person in ten thousand (10 percent to the fourth power) has the full skill set. Perhaps I am being overly pessimistic. After all, these four abilities may not be entirely independent: if someone is smart enough, it is also more likely he or she will be interested in finance and be driven to delve into financial history.
But even the most optimistic assumptions — increase the odds at any of the four steps to 30 percent and link them — suggests that no more than a few percent of the population is qualified to manage their own money. And even with the requisite skill set, more than a little moxie is involved. This last requirement — the ability to deploy what legendary investor Charley Ellis calls “ the emotional game ” — is completely independent of the other three; Wall Street is littered with the bones of those who knew just what to do, but could not bring themselves to do it.
I am most interested in the emotional game. We use a systematic investment process that is objective and unemotional for just that reason, but our firm is rare in the industry. Most everyone else flies by the seat of their pants for security selection and asset allocation. It’s very possible to have some remarkable successes that way when you hit something just right, but it’s very difficult to sustain the success, especially when, as Bernstein phrases it, the tide goes out.
I was working late last night on proxies (fun, fun) and happened to answer a call from an investor interested in using our services. He talked a good game, told me all about his views on the dollar and the market, and told me that he was a “sophisticated investor.” But what had he done? He was invested with a value manager and hung in until November 2008, when he finally lost his nerve and sold out. He mocked the value manager for continuing to buy on the way down because securities were perceived bargains, although that is pretty much the job description for a value manager. He felt good that he had missed a few months of the bear market, from November to March 2009. But he never had the nerve to get back in, and railed against the rise in the market as a “false rally.” I’m sure that characterizing market action that way helped ease the sting of completely missing the boat. Since the S&P 500 is now higher than it was in November, his emotions have cost him a fair amount of money. This is a very typical investor and a very typical sequence-the first story or impression you get is rarely the whole story. The client was pretty sophisticated about markets, but totally lacking in emotional resilience.
Following the path of least emotional discomfort is a road to failure. In my view, using a tested, systematic process is the only way to succeed in the very long run.
Posted by Mike Moody 
