I was attending a dinner party just after the great crash of ’08, when a friend asked me what seemed like a very simple question, “what makes someone like Buffett such a great investor?”. Reflexively I responded with the obvious answer, “he’s just smarter than everyone else”.
The second the words left my mouth, I realized not only that I was wrong, but the response must have seemed foolish to my enquirer. My friend, David, holds both an M.D. and PhD, and his doctorate happens to be from Harvard in the field of physics. I’d be willing to bet the farm David could match Warren Buffett, Ray Dalio, Bill Gross, or any other billionaire money manager point for point on an I.Q. test. He may even exceed them.
David’s response cut straight to the flaw in my thinking.
“But there are lots of bright people in the world” he said, “and they’re not all good investors. In fact, a lot of them are quite bad at it.”
Of course, that’s precisely the problem. David himself is not a billionaire nor an investing mogul. While successful, David still has to fly commercial and drive his own car, just like the rest of us.
So if raw brainpower doesn’t automatically make someone a great investor, why? And what does?
These two questions have been on my mind for years, and I’ve never been able to come up with a satisfactory answer, until I read Ray Dalio’s book, Principles. In addition to providing a number of incredible insights, the book has helped me answer the question David asked nearly a decade ago.
Being highly intelligent is a necessary component of being a successful investor, but it’s not sufficient. I’m willing to bet that the world’s greatest investors have another aspect of their personalities in common, which sets them apart from those of us with middling intelligence, and from their intellectual peers. This particular skill is the ability to see the world as it really is, and make decisions about future outcomes based on a limpid and dispassionate world view. In other words, they’re masters of reality.
So what the hell is reality anyway? Is there even such a thing? Those are also good questions, and it turns out reality is an actual thing and there are even methods for determining what it is. As Dalio points out, were there no reality, then planes wouldn’t fly and cell phones wouldn’t work. Therefore, the best way to discern reality is through scientific principles.
In physics for example, several observers can have vastly different perceptions of the same event, and yet all can be valid depending on the observer’s position relative to the event. Assume two people were standing 100 yards apart and I were between them holding a siren. If I were to run towards one of the observers, that person would experience the siren as increasing in volume, while the other observer would experience a decrease in volume, and I would experience the siren volume as unchanged.
Somehow the three different experiences of this same event are all equally valid. If a great investor were making a bet on the outcome of this experiment, would they say the siren volume increased, decreased, or stayed the same?
My hunch is that a great investor could bet on any of the three and reap the rewards. That’s because there can be multiple perspectives within reality, which would explain why so many investing philosophies work. Were reality singular in nature, then there would only be one way to benefit in life and investing and it would just be called, “The Way”. But there isn’t just one way, there are many ways. Investors like Buffett, Dalio, and Gross all have very different investment styles, but all three men win more often than they lose because their predictions about tomorrow are founded in reality, which maximizes their probability of being right. Since the odds are almost always in their favor when they make an investment, they win a lot more than they lose.
Where the rest of us tend to get into trouble is when flaws in our thinking (perhaps the result of intellectual laziness, breakdowns in our logic, or emotional-psychological filters that distort our view of the world), lead us to making decisions that would require an atypical outcome in nature in order to be proven right.
In keeping with the example above, an unsuccessful investor wouldn’t have a firm enough understanding of reality to bet on the volume increasing, decreasing or remaining static. Instead they would select a fourth option like the volume wildly fluctuating up and down. Such a result might happen on occasion but that would be outside of nature, and therefore unlikely to repeat consistently enough to result in a successful investing career.
So how do we know if we’re seeing reality clearly? According to Dalio, it’s all about understanding nature and its driving forces, particularly evolution. Nature will automatically optimize for the best outcomes by prioritizing creatures, systems, and businesses that most benefit the evolutionary process. Therefore, the people who align their interests with evolution are the most likely to be rewarded.
Like species, companies must evolve or they’ll die. Take one of Buffett’s most famous investments, Coke. The company is an American institution, yet the company and its eponymous product have changed markedly over the years. Coke’s formulation today is far different than the original (cocaine was actually one of the ingredients), and the variety of flavors and beverages offered by the company has also grown and evolved.
Imagine if Coke’s management team had held steadfastly to the original recipe and insisted that the company not sell any other food or beverage other than Coke; how might the company have fared over the decades? Probably not too well. Buffett knew Coke had a great product and an iconic brand, but he was also betting on the company’s ability to evolve.
So to answer the question I was posed all those years ago, most of the great investors possess both uncommon intelligence and a firm grip on reality. Armed with this unique skillset they’re able to make accurate assessments about the world today, so they can predict where things will likely end up tomorrow. The moral of the story is, if you want to improve your skills as an investor, begin by working on your ability grasp reality.
Hypocrisy Knows No Bounds
The Kentucky Derby two weekends ago featured the greatest hypocrisy of my lifetime. The winner of the race, who I featured as my Derby pick in the April Newsletter, was disqualified and placed 17th. The stewards (judges) that reviewed the race claimed the winner caused other horses (who had no chance of winning) to lose any shot of winning the race. Horse safety has been tossed around as a reason why the rules are what they are and also justification for the disqualification of the rightful winner of the race. If horse safety mattered then why on Earth were there nearly 20, baby 3 year old horses in the starting gate on a slippery muddy track? If horse safety matters why did Churchill Downs have the track packed to the gills resulting in enough noise to make a jet engine blush? The answer, as always, is money. I prefer entities and people give it to me dirty so I don’t get dirtied, as I did in the Kentucky Derby.