How to beat genius investors?

HOW TO BEAT GENIUS INVESTORS?

This article was written by Chad Slater for the AFR. You can read the original column here. 

Let’s start with two anecdotes with catastrophic consequences.

On the 23^rd of September 1998, one of the world’s previously most successful hedge funds, Long Term Capital Management (LTCM), collapsed with losses of $US4.6 billion ($6.5 billion) in two months, taking the world to the brink of a GFC-style collapse causing the Federal Reserve to bail out the company and unwind the nearly $US100 billion of exposure to markets.

Roger Lowenstein writes in detail about the “smartest guys in the room” in When Genius Failed: The Rise and Fall of Long-Term Capital Management. LTCM was famously staffed with two Nobel Laureates (Myron Scholes and Robert Merton) and of the eight partners, seven had PhDs (six from MIT alone).

On the 28th of January 1986, the NASA space shuttle Challenger was destroyed 73 seconds into flight, killing all seven crew members instantly. The Rogers Commission that examined the accident was damning about how decisions were made at NASA, with Richard Feynman, a physicist in the twilight of his illustrious career, leading the charge against NASA management’s risk assessment procedures where obvious flaws and issues were covered up or ignored.

Both these teams contained some of the smartest people in America, if not the world – leaders in their respective fields. Yet in both cases, they destroyed either peoples’ lives or markets and careers.

Adam Robinson was recently interviewed on the Farnam Street Blog on a fascinating topic called “How not to be stupid”. He defined stupidity as overlooking or dismissing conspicuously crucial information and identifies seven factors that increase the likelihood of “stupidity” occurring:

• Being in a group where social cohesion comes into play
• Being in the presence of an “authority”
• Fixation on an outcome
• Information overload
• Rushing or urgency
• Stress
• Being outside of your circle of competence (readers will recognise this one!)

Any one of these increases the risks, in combination they are additive, with the Challenger disaster having all seven present.

What makes “stupidity” so dangerous is that it is usually committed by smart people.

Smart people (as opposed to “thick” – which is the true opposite of smart, and can be defined more as an inability to cognitively process information) are promoted to positions of power on the basis of their intelligence.

Yet smart people also suffer more often from the cognitive inhibitor of “overconfidence”, with doctors (again a subset of some of the smarter members of the community) renowned for this.

In fact, Robinson cites hospitals as one of the leading examples of where “stupidity” occurs. A little-known fact: In the US every year, there are roughly 30,000 fatalities from car accidents.

How many deaths accidentally occur in hospitals every year? In other words, you go in with a broken arm and you don’t come out. Not, you died as a result of what you went in for. Robinson says the current best estimate is 210,000 to 440,000 people die every year in the US from hospital error.

So what can be done about this? The answer is surprisingly simple and is often found as an antidote inside the aforementioned hospitals. Create a checklist. Atul Gawande in The Checklist Manifesto: How to get things right writes that this simple task, well-constructed and used properly, can dramatically reduce error rates. If you’ve ever flown in a small plane, you’ll have seen the pilot literally flipping the tabs over on his checklist on the controls.

So how does this relate to markets and investing? Firstly, be aware of which sort of places may lead to a higher probability of these factors combining. I would say the Federal Reserve is susceptible to these factors. Indeed, the rapid walk-back from the December rate hike, which now looks like an error (but even at the time seemed to be an error), whilst admirable, is still potentially costly.

Be wary of groups of experts offering strong opinions. Don’t be afraid to disagree with them. Keep a diverse group of friends. Be open-minded. As discussed in other columns, having a plan in advance or a checklist can put you at a large advantage over people smarter and better informed than you.

But if there is one thing that I’d emphasise the most, it is to be self-aware enough to not make large decisions when tired. Almost by definition you are at risk: just don’t make a decision, or to use an old saying, “sleep on it”.

Because you may not be a Nobel Laureate or a physicist, but if you can stop yourself from “stupidity”, often you finish ahead of those smarter than you.