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The Wicked Smart Investor: Even a brilliant investor can make disastrous mistakes

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By Chris Hanson

 

I’ve always wondered how Sir Isaac Newton, one of the smartest men that ever lived, lost a fortune in the stock market. I went back to school early this year and found out why.
Babson College was founded by a very peculiar old Yankee named Roger Babson. In childhood, Roger lost his sister in a drowning accident and he blamed the whole thing on gravity. An MIT graduate, Babson became obsessed with Newton’s discovery of the earthly force, and any chance he got, Roger collected Newton’s artifacts, including the fore-parlor of Newton’s house in England. This room is preserved in the college’s archives and, strangely enough, it reminds me of my first school, Hollis Elementary in Braintree.

Sifting through the archives on campus turned out to be a very eerie exercise. The archivist let me sit in that parlor while I researched; I could have been in the very same room that Newton was when he learned of his financial calamity. When no one was looking, I tried to get the walls to talk; I imagined they could tell me the exact 18th Century cuss words Newton used when he was delivered the blow. The walls didn’t budge. Frustrated, I took a stroll in the small orchard outside and discovered the trees actually descend from the tree that plopped the apple on Newton’s head. As every family has some folklore, I interviewed them too. I figured they would feel safe telling an alum, but I couldn’t persuade them to talk either.
Finally, I returned to the traditional research methods that got me through the challenging graduate program. My results are not what many would expect. Upon learning this ugly bit of Newton’s biography, some may speculate that the apple hit him on the head a little too hard, or his then-fashionable powdered wig fit too tight and cut off the circulation to his brain. But his financial disaster was caused by something very unspectacular. As brilliant as he was, Newton got caught up in an investment bubble like many far less cerebral investors.

Let’s review the facts: In 1720, Newton owned shares in the South Seas Company, an exporter. It was one of England’s hottest stocks, and it really got the teakettle boiling. Newton sensed the market was overheating and he sold his shares for 100% profit. He should have quit while he was ahead, but he didn’t. Newton got swept up in investor enthusiasm, or what some call the madness of crowds, and repurchased the shares at a much higher price a couple of months later. In a few weeks, the stock price crashed, Newton panicked and dumped the stock at a huge loss. All told, the damage was about $3.5 million in today’s money. This from the man who invented calculus!

I’d like to say I am surprised at this story but I am not. As an experienced investment advisor, I’ve seen countless smart people make huge financial blunders. What causes these missteps is our own human frailty and not a low IQ. Our brains are still wired like the cavemen. Circuitry that helped us survive prehistoric times can lead us to poor financial decisions now. Behavioral Finance is the field of study exploring these strange phenomena. It is fascinating and I have learned a lot reading books like Predictably Irrational: The Hidden Forces That Shape Our Decisions, by Dan Ariely.

Here’s an explanation of some of the decision-making obstacles we’re born with:
Herd Mentality: Describes how people are influenced by their peers and adopt certain behaviors. Think of it; things are always easier when you stick with the crowd. Newton fell victim to the mob rules when he repurchased the stock. Remember the mass hysteria over Krispy Kreme’s stock? It was supposed to put Dunkin’ Donuts out of business according to some. The implication was you’d be a fool if you did not invest in the hot donut maker. Well, KK failed in Boston and Dunks is still here. ’Nuff said.

Hindsight bias: Many investors like to believe the market is more predictable than it is. For example, if a stock or mutual fund went up 30% last year, many think it’s the one to purchase this year for certain big gains. That’s absolutely wrong. Such huge increases are unlikely to be sustained. Last year’s hot stock is seldom the winner at the end of this year. Successful investing is not that easy.

Confirmation Basis: My name for this is opinion shopping. You believe something to be true, maybe because your dear old Uncle Joe told you so. Then, you’ll go out and find an advisor who agrees with you while you ignore any advisors who contradict this viewpoint. What if Uncle Joe was actually wrong? You should at least do some research to ascertain if the opposing advisors are correct. Most people don’t. They just keep looking until they find an advisor who agrees with sainted Uncle Joe. It’s usually at their own peril.

Cognitive Dissonance: This is the inner struggle that exists when evidence is discovered that tells someone his common beliefs are wrong. This is what I experienced one Christmas morning in the 1970s. All of my presents read “To Christopher from Santa Claus,” yet all the handwriting on the tags was Ma’s. I wanted to believe in Santa so I just ignored the smoking gun right in front of me. I bet some of you are experiencing this struggle now as you think about your investments with this new information.

If you could be a fly on the wall during my meetings, you’d see how common these biases and investing hindrances really are. When I critique someone’s investments I take special care to be very diplomatic, yet people are still defensive. Many feel that if they have success in one area, that automatically makes them an expert investor. They will tell me about the degrees they’ve earned, their titles at work and the value of their home. I’m honestly happy and impressed my clients have these things, but the market can be brutal and simply doesn’t care if you graduated Summa Cum Laude.

The take away is that becoming more self-aware will make you a better investor. Understand we all have biases; we’re only human, and even smart people can’t control that. Focus on what you can control. If you are working with a qualified advisor, understand that they are critiquing your investments for your benefit. A true professional appreciates that your talents lie elsewhere.

In the end, part of the value an advisor provides is discipline. As he has an arm’s length relationship with your investments, he can see the orchard through the apple trees. Like a good offensive lineman, your advisor will run interference when you get caught up in market euphoria and shield you from making rash decisions when the market falls like Newton’s apple. As a result, you’ll be more successful and see a smarter, and likely wealthier, version of yourself in the mirror.