Source: Lonely Brain
Author: Lao Yu

Intelligent individuals are prone to committing two types of errors:

1. Believing that intelligence comes easily, they tend to underestimate others' foolishness.

2. Relying on their intelligence for success, they further underestimate their own foolishness.

The consequences of the second type of error are more severe.

In other fields, intelligent people can use their exceptional intellect to compensate for their shortcomings, often with considerable surplus.

However, in the field of investment, this approach does not work.

Elsewhere, intelligent individuals may be excused for their cleverness;

but when it comes to investment, smart individuals are often punished precisely because of their intelligence.

In terms of investment, the first priority for wise individuals is to overcome their own foolishness and become rational.

Only then can they fully utilize their intelligence.

The framework of this article is derived from the book Principles of Behavioral Investment. The book is rather conventional; the author appears intelligent, sincere, and correct, and reading it is thought-provoking. Approximately more than half of the following content consists of the author's reflections.

Principle 1: Control your behavior

The primary issue for investors, as well as their greatest enemy, is themselves.

——Benjamin Graham

Reflection: Controlling one’s behavior is often an empty phrase; perhaps only professional investors can achieve it (though maybe not even they can).

Therefore, the best approach may be to learn from Odysseus: set clear rules in advance, then block your ears and have yourself tied to the mast.

Regularly investing in appropriate index funds or value investing based on one’s circle of competence may resemble this logic.

Mental accounting is also a useful tool.

Divide your money into several mental accounts in advance, one of which is designated for long-term investment. Set up an automated process to transfer funds to your investment account over the long term, with the amount increasing alongside salary growth.

Principle 2: Do not reject advisors.

Reflection: This is challenging because one's position often dictates one's mindset, and typically, most advisors are in a somewhat conflicting position with you. There is an interesting perspective in this book that I particularly like:

The best way to utilize a financial advisor is to treat them as a behavioral coach rather than an asset manager.

Here is an excerpt: Vanguard's 'Advisor's Alpha' effectively quantifies the value-added contributions of investment advisors across various daily activities (measured in basis points (bps)), and the results might surprise you. · Asset rebalancing: 35 bps · Asset allocation: 0–75 bps · Behavioral coaching: 150 bps Interestingly, the data above shows that behavioral coaching provides more added value than the other two activities more closely related to money management.

Approximately half of the additional 3% return can be attributed to behavioral coaching, or to the advisor preventing clients from making foolish decisions driven by fear or greed! Therefore, sometimes it is more valuable for an advisor to manage your emotions than to manage your money. This reminds me of a previous realization:

The primary role of a house designer is to prevent the homeowner from making mistakes.

Furthermore, when it comes to making money, it is extremely difficult to be a hands-off manager.

Investing in stocks may be one of the best ways to adopt a hands-off approach, but it also comes with corresponding costs.

A person who does not understand business operations and the essence of commerce will find it difficult to invest in stocks using a value investing approach.

Buying funds, which seems to outsource decision-making to smart professionals, allows one to enjoy the privileges of being hands-off but also comes at a cost.

There is no such thing as a free lunch. The extent to which someone acts as a hands-off manager corresponds to the degree of other forms of effort or sacrifice required.

Among these, independent thinking is always essential.

If a hands-off manager not only relinquishes control but also abandons independent thinking, the outcome will be quite unfortunate.

Principle 3: Trouble is opportunity

Buy when sentiment is at its most pessimistic and sell when it is at its most optimistic.

— Sir John Templeton

So, do you think the current situation is troublesome enough to present an opportunity?

Ben Carlson discovered:

"The best periods for market returns often do not occur during transitions from good to better, but rather during shifts from bad to less bad."

This statement is remarkably insightful, with at least two standout points.

a. Earning profits does not necessarily rely on a favorable market, but rather on advantageous volatility.

b. Favorable volatility can occur even during a 'junk time period.'

Speaking of how to maintain stability in turbulent situations, last spring break on Maui Island, when I tried paddleboarding for the first time, I discovered that the secret to staying balanced is to not focus on your feet but look further ahead, feel the waves, and move with them.

Investing and raising children also share similarities:

"Investing is like raising teenagers; experienced parents know that the focus should be on long-term growth rather than every minute detail of daily life."

The book offers a valuable suggestion:

Create a list of companies you are interested in, whose stock prices may currently be somewhat high, and the next time market fluctuations make their prices more attractive, purchase them decisively.

Principle 4: Avoid emotional influences.

If you think investing is a form of entertainment and find it enjoyable,

you may not make money. True investing is actually quite boring.

— George Soros

Financial writer Walter Bagehot wrote: 'All people are credulous when they are happiest.'

The same is true when angry or fearful.

The book provides ten suggestions for managing emotions:

(1) Engage in high-intensity exercise.
(2) Redefine the problem.
(3) Limit caffeine and alcohol intake.
(4) Talk to friends.
(5) Do not react immediately.
(6) Distract yourself.
(7) Label your emotions.
(8) Write down your thoughts and feelings.
(9) Challenge catastrophic thoughts.
(10) Control every possible aspect.

Due to biases caused by emotions, sometimes we need to recalibrate our behavior. A specific suggestion is as follows:

Set up a small investment account (approximately 3% of your total wealth) for various experiments, ensuring that this account is kept separate from your long-term investments.

Principle 5: You are just an ordinary person

You are not special. You are not a beautiful and unique snowflake,

You are merely a collection of perishable organic matter, just like everyone else.

— Chuck Palahniuk, Fight Club

Uh, do you think you're ordinary?

Aren't all those motivational articles reminding us that every individual is unique?

The boastful writings of various experts make us feel as if they are gods and we are nothing.

But who isn’t an ordinary person?

Being a happy, ordinary person might just be the happiest thing in this world.

The Cook Institute conducted a study asking people to rate the likelihood of certain positive events (such as winning the lottery or finding a lifelong partner) and negative events (such as dying of cancer or getting divorced) occurring in their lives.

As expected, participants overestimated the likelihood of positive events by 15% and underestimated the likelihood of negative events by 20%.

Principle 6: Focus on your own needs

The so-called wealthy,

refer to those whose assets exceed their brother-in-law’s by 100 dollars.

- H. L. Mencken

Do not make comparisons.

Comparison is the root of all evil.

Only focus on your own accounts and do not concern yourself with how much others earn.

As Jason Zweig said:

"Investing is not about beating others at their game; it’s about excelling in your own."

Achieving this is extremely difficult.

Not even geniuses are exempt.

During the speculation frenzy over the South Sea Company's stock, Newton became wealthier and then exited the market with his principal and profits.

However, after Newton left the market early, many of his friends (far less intelligent than him) continued to hold onto their stocks as prices kept soaring.

Although Newton was already financially secure, he could not tolerate seeing his friends and neighbors surpass him in wealth. Consequently, he soon re-entered the market to buy shares at the peak of the bubble, only to witness a sharp decline in stock prices thereafter.

Newton may have thought at the time: How could I allow those fools to earn more than me?

Moreover, money earned through speculation is really difficult to truly keep in one’s pocket.

Few are willing to voluntarily leave a festive gathering.

Principle 7: Do not blindly trust forecasts.

The wise do not gamble; those who gamble are not wise.

— Laozi

The stock market is unpredictable.

The book states that contrarian investor David Dreman discovered that the majority (59%) of “consensus” forecasts on Wall Street were so far off that they became entirely worthless — deviating from actual outcomes by as much as 15%.

Dreman further analyzed nearly 80,000 forecast data points from 1973 to 1993 and found that only 1 in 170 forecasts had an error margin within 5% of the actual results.

Therefore, investing based on forecasts is also perilous.

Reflection: "This person absolutely lacks foresight. This person absolutely lacks foresight. This person absolutely lacks foresight."

Question: "Is this forecast based on probability, measurable, and thoroughly researched? How accurate were this person’s previous predictions?"

Principle 8: Everything will pass.

Much that is now in decline will revive;

much that is now glorious will decline.

— Horace (Ancient Roman poet)

Lincoln once said:

It is said that an Eastern monarch once asked his wise men to give him a piece of advice that would be applicable at all times and in all situations. The wise men gave him the advice: 'This too shall pass.'

How profound this statement is! How sobering in moments of pride! How comforting in times of sorrow!

Mean reversion, like gravity, is inescapable.

For example, even the most capable fund managers often do not last long. (There are very few exceptions, and it takes a long time; besides, who knows if it is just survivorship bias.)

However, how should we distinguish between mean reversion and the Matthew Effect?

For instance, in recent years, those technology companies seem to be getting bigger and bigger.

Therefore, for ordinary people, buying low-cost index funds in good markets through appropriate means may be a suitable choice.

Principle 9: Diversification requires trade-offs.

I think my formula might be:

Dream, diversify, never be stubborn.

—Walt Disney

Too many successful people like to emphasize their focus. For example, both Charlie Munger and Buffett stress concentrating on a few big opportunities.

But they are not ordinary people, are they?

It is said that the early tradition of the Jewish people was to allocate one-third for commercial operations, one-third as cash reserves, and the remaining one-third as fixed assets.

In fact, diversification and rebalancing have been proven to help boost performance by an average of half a percentage point annually. This figure may seem small at first glance, but it is important to recognize that over the course of your lifelong investment plan, it will compound over time.

The book "The Investor's Manifesto" mentions stocks from Europe, the Pacific region, and the United States, with annualized returns from 1970 to 2014 as follows:

· European stock market: 10.5%

· Pacific region stock market: 9.5%

· U.S. stock market: 10.4%

The returns appear similar, but let us examine what happens if all the stock markets are combined, equally weighted, and rebalanced annually at the end of each year — the average annual return of this portfolio during this period would be 10.8%, higher than the returns of any individual stock market!

This can only be described as the miracle of diversified investing! Every market has years when it performs well or poorly, and automatic rebalancing allows you to sell profitable stocks and buy those that have declined.

The book introduces a concept: "variance drain":

It refers to the detrimental impact of low values during troughs being amplified when investing in a highly volatile manner. Even if the arithmetic average remains the same, the variance drain can have a significant effect on accumulated wealth.

This actually refers to the difference between the arithmetic mean and the geometric mean. The latter determines the overall growth of wealth.

The book I like, Safe Haven, is basically about this one concept.

For example, the following two investments, which both appear to have an arithmetic average return of 10%, actually yield different results:

1. You invest $100,000 in 'Product A' for two years, with an annual increase of 10%, resulting in a final total value of $121,000.

2. You invest $100,000 in 'Product B' for two years, with annual returns of -20% and 40%, also achieving an arithmetic average annual return of 10%. However, this investment is only worth $112,000, which is $9,000 less than the other investment with lower volatility.

In reality, however, those who invested in Product B might seem more impressive, as they achieved an astonishing 40% annual return rate.

In fact, Product A is clearly the winner.

Action: To achieve diversification across asset classes, a portfolio should include at least domestic stocks, foreign stocks, fixed-income assets, and real estate. (The author is based in the United States; please apply critical thinking when learning.)

Principle 10: Risks follow discernible patterns.

October is a particularly dangerous month for stock speculation.

The other equally perilous months are July, January, September, and April.

November, May, March, June, December, August, and February.

— Mark Twain, 'Pudd'nhead Wilson'

Previously mentioned was the harm volatility causes to geometric averages. In this section, the author writes:

The advantage of using volatility as a measure of risk is that it is extremely simple and easy to quantify, can be included in reports, and can be described by elegant (mostly useless) mathematical models.

However, the danger of using volatility as an indicator of risk is much greater: it actually fails entirely to measure what it is supposed to measure.

Howard Marks provided the explanation:

Scholars use volatility as a synonym for risk purely out of convenience. They need an answer for their calculation formulas — one that can be justified historically and used to infer the future. Volatility meets this requirement; other forms of synonyms do not.

However, the issue is that I don't believe volatility is what most investors care about. I think the reason people reject investments is primarily due to fears of capital loss or unacceptably low rates of return, not volatility.

To me, 'I need more upside because I'm worried I might lose money' is far more convincing than 'I need more upside because I'm worried prices might fluctuate.' Yes, I believe so-called 'risk' (first and foremost) is the likelihood of losing money.

So, what exactly is risk? --

Definition of risk: The possibility of permanent loss of capital and the possibility that we may not be able to achieve the life of our dreams.

Well, this definition seems clear and clever.

Simply put, never bet with money you cannot afford to lose.

Speaking of risk, it is necessary to mention stocks again. Of course, all discussions in the book are based on the U.S. market, so we should critically reference them:

Jeremy J. Siegel mentioned in 'Stocks for the Long Run' that from the late 1880s to 1992, if measured in 30-year cycles, the performance of stocks always outperformed bonds and cash;

If measured in 10-year cycles, stocks performed better than cash in 80% of cases;

If measured in 20-year cycles, stocks have never incurred losses. Bonds and cash, as measured by volatility standards, are generally considered safe. But in reality, they have never been able to outpace inflation.

Another description of volatility was also mentioned by Taleb, related to probability, which is quite interesting:

If you check your account every day, you will have a 41% chance of seeing a loss. And we know that the pain caused by loss is twice as strong as the pleasure brought by gains, which will make you feel very uncomfortable!

And if you look once every five years, the probability of seeing a loss is only 12%.

And if you look once every 12 years, you will never see a loss.

Twelve years may seem like a long time, but honestly, it goes by in the blink of an eye...

Wishing everyone a long life, and let us learn from Buffett and Yang Zhenning.

Howard Marks said:

Throughout my career, I have observed that the performance of most investors depends more on how much and how severe their losses are rather than on the extent of their gains.

Proficient risk control is the hallmark of a sophisticated investor.

Bernstein (author of 'Against the Gods') believes:

The essence of risk management lies in maximizing the areas where we have control over outcomes and minimizing the areas where we have no control, though we cannot ascertain the causal relationships within.

There is an example originally meant to illustrate volatility, but I think it serves as an excellent lesson on 'how to conduct oneself'—

Nassim Taleb said: If a person always arrives home precisely at 6 o'clock every day, then after some time, even if he is only five minutes late, his family will worry about his safety.

Let us imagine another person who arrives home around 6 o'clock each day, sometimes at 5:30 and sometimes at 6:30. The uncertainty in his arrival time makes his family less concerned unless one day he comes home significantly later than usual.

This example reminds me that it is acceptable for a person to occasionally act inconsistently; otherwise, if you are always uniformly kind, even the slightest deviation might provoke criticism.

Going deeper, this reflects Franklin's wisdom:

Never let others know what you are truly thinking.

Of course, your closest friends are an exception.

Finally

In summary, the above ten points ultimately revolve around how a person can transform themselves into a rational decision-making machine while accepting the inherent imperfections of such a machine—such as being overly emotional, impulsive, obsessed with narratives, or driven by desires.

Furthermore, based on acknowledging these irreparable flaws, we must design an Odyssey-like epic journey for ourselves and recognize when to tie ourselves to the mast.

Over the past few decades, intelligent individuals have focused on how to become winners and achieve more victories.

In the coming decades, perhaps intelligent individuals should reconsider:

How to avoid becoming a loser, and lose less when losing is inevitable.

Then, whether in good times or bad, rely on rationality to still make money and protect the funds that cannot afford to be lost.

Editor/Jayden