The Disadvantage of Smart Investors

06/24/2011 8:30 am EST

Focus: MARKETS

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Are you smart? Did you do well in school? Well, by being “smart,” you suffer from a huge handicap in becoming a profitable trader, observes Nicholas Vardy of The Global Guru.

Some people are born smart. Some people are born lucky. Some people are smart enough to be born lucky. —Ed Seykota

If intelligence were the key, every finance student who graduated with a PhD from Stanford or MIT who tried his hand at trading would be filthy rich…

And unless they happen to be savvy poker players with a strong dose of practical, hard-earned street smarts, they probably aren't. Understanding why this is the case can help you make—or better yet, help you keep—your hard-earned investment profits in the market.

You've heard this story before. Picture this…

You are a financial analyst at a top investment bank. You recently graduated from Harvard Business School, and all your friends and family think you’re pretty smart.

After all, you always won all of the spelling bees and math contests that you entered since you were a kid—and you got great grades in college while most of your peers slacked off.

So you research a red-hot Chinese Internet stock IPO. You speak to the management. You run your complex financial models. You value the company at $14 a share.

You write a “buy” recommendation. This is then distributed to your employer's leading institutional clients, who are responsible for investing tens of billions of dollars in the global financial markets.

After the company is listed, the stock shoots up to $24. If anything, your valuation makes you look overly conservative.

Then the stock starts dropping. Within five days, the stock is down to $14, and then falls further to $10.

You run your models. You still come up with the $14 target price.

The stock is now at $8—one third of its peak trading price from just a month ago—and almost half of your current valuation.

But as an analyst, you “know” the stock is worth $14. You'll do anything to avoid admitting that you're “wrong.”

This story has been repeated thousands of times on Wall Street. In fact, this anecdote recounts the recent fate of Renren (RENN)—The “Facebook of China.”

The stock was a hot IPO a month ago, soaring on its first day of trading. Then it promptly fell off the table.

NEXT: The “Tiny Flaw” in Smart People

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The “Tiny Flaw” in Smart People
Smart people have a tiny little flaw in them that makes them highly unsuitable to be traders and investors…

Consider the results of an experiment conducted by “Trader Vic” Sperandeo, one of the top traders profiled in the original Market Wizards book by Jack Schwager.

Having been entrusted with building a trading operation, Trader Vic hired and trained 38 traders. He assembled a diverse group, as he wanted to find out whether there was any correlation between intelligence and trading success.

The results were revealing. Five of the 38 traders made more money than the others combined…

One of the five who made it was a high-school dropout who, according to Sperandeo, “didn’t even know the alphabet.” One who made no money in five years had an IQ of 188 and was a champion on Jeopardy.

Why? The “smart” traders could never bring themselves to admit that they were wrong.

Smart People Love Information
They think information—and ever-more-complex financial models—are the key to making correct investment decisions…and the more information you have, the better decisions you make.

But here’s the reality: There’s always more to know. And the more complex the model, the less “robust” or accurate it is.

The real problem, however, is psychology. Smart people have a bad case of what trading psychologists call “need-to-understand” bias and “need-to-be-right” bias.

That's why, after making an initial recommendation, they spend most of their energy proving that they were right in the first place…

The Lesson You Should Learn
So, here is the irony: being a “smart” analyst often makes you the worst trader. And don’t be overly impressed with an analyst's employer or academic credentials.

  • George Soros failed his Charted Financial Analyst (CFA) exams twice, and then gave up.
  • Warren Buffett was rejected by Harvard Business School.
  • Meanwhile, an analyst at a top investment bank may—unlike George Soros—pass her CFA exams on the first try.

But that has nothing to do with her ability to manage money, especially if she spends all her energy trying to prove that her analysis deserves an “A”—the same grade she got on her thesis at Princeton.

More importantly, don’t be too impressed with your own “analysis” either. Never bet too big on any single idea, no matter how compelling the story… and always have your exits in place.

That is, unless, you were—as Ed Seykota says: “smart enough to be born lucky.”

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