What separates good investors from great investors
Michael Mauboussin, from Legg Mason, recently released a great article about the difference between good and great investors.
The first issue he highlights is that great investors avoid being destroyed by high impact, rare events. For example, many value investors avoided investing in dot-com stocks during the late 90’s and looked liked fools until the market tanked between 2000-2002. Great investors aren’t great because they can predict such events, but because they have learned to avoid them.
The second issue he highlights is that great investors have the right temperament. By this, he means they don’t get sucked into the psychological traps that most people get sucked into.
For example, most people feel the pain of losses (loss aversion) so much more than the pleasure from gains that they make bad choices. What if I offered you a game where you had a 95% (19 out of 20) chance of losing $5 and a 5% (1 out of 20) chance of making $100, would you play? Would you play if you could play it an unlimited number of times? Most people wouldn’t play this game because they would feel the pain of losing more than the benefit of gaining, even though they would make money with no effort as long as they kept playing the game. Great investors understand this math and would play.
Great investors also understand the difference between probability and impact. In the example above, you have a high probability of losing, but when you win it has a very high positive impact. Most people over-emphasize the probability and under-emphasize the impact. Great investors understand the difference and play accordingly.
Great investors also grasp the randomness of any game they play. Short term results in the stock market are so random that someone with little skill can get wonderful returns over short periods of time (like a day, month, year or even 3 years). Only over the long term can you see who has skill. Great investors get this and judge their investing options over the appropriate time horizon.
Mauboussin concludes his article by pointing out that high impact, rare events, loss aversion, probability and impact, and randomness requires great investors to focus on 3 things: process versus results, a constant search for favorable odds while recognizing risks, and an understanding of the role of time.
Investors who follow this advice and can act on it have the potential of being great instead of merely good or even bad investors.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.