The Smartest Person in the World Can Still Be a Terrible Investor

Have you ever felt intimidated by the markets? Thought that investing was only for really smart people?  Maybe you hear jargon like “beta”, “derivatives”, or “standard deviation” and it just goes over your head? Contrary to what you may think, you can be the smartest person in the world and still be a terrible investor.

If I told you history’s most famous physicist failed miserably at investing would you think differently? Sir Isaac Newton, the man who conceptualized three laws of motion, pioneered calculus, and discovered the color spectrum among other accomplishments, was a terrible investor.

Setting—England, early 1700s. The South Seas Company is formed in anticipation of having a monopoly on trade to the Spanish colonies in South America after the War of Spanish Succession (1701-1714). The outcome of the War did not bode favorably for the company. Even though the company had completed no voyages to the new world after 5 years, its leadership turned to advertising false claims of success and wild (but false) tales of the company’s adventures.

It was during this time that Sir Isaac Newton invested in the company, watched the stock rise, and sold making a handsome profit. Filled with greed and regret that he gotten out too early as he watched his friends make more money, he jumps back in, this time with an even bigger bet. Shortly after, the bubble bursts and the sell-off begins. Newton loses the majority of his fortune and supposedly forbids anyone to utter the words “South Seas” in his presence ever again.

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You might say, that’s interesting, but that was also 300 years ago. Things are different today and with the information and technology available to us now, this amusing tale of Sir Isaac Newton is no longer relevant. A lot of things about our world has changed since the days of Newton but human nature has not.

Fast forward to the year 2000. Take the people with IQ’s in the top 2% of the population and see how they do at investing. Eleanor Laise did exactly that when she looked at the investment performance of the Mensa Investment Club between 1986 and 2001. She found that Mensa had a 2.5% average annual return. Compare that to the S&P 500 which had a 15.3% return during the same period. Not much has changed after all- smart people can STILL be terrible investors.

We may have put a man on the moon, cured polio, and created the internet in the past 300 years but we are still not immune to being really bad investors. If smart people can fail at investing what does that mean for the average person? It means that you don’t have to have a top IQ or have invented the telescope (Newton pretty much did that too). It just means that you 1) need to invest for the long-term and not be swayed by the latest buzz and 2) you need to be disciplined to ride out the inevitable ups and downs of the markets.

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Is Relying On Stock Markets For Economic Signals A Mistake?

Wouldn’t it be great if investors could navigate the markets like we navigate through traffic- -guided by red, yellow, and green lights? If we had signals that told us with certainty what direction the economy was headed, then we might have an edge in our investment strategy; we would know when it was a good time to invest, when to proceed with caution, or when to put the brakes on.

Unfortunately, the reality is that the market is murky and unpredictable. As the economist Paul Samuelson once put it: “The stock market has called nine of the last five recessions.” The market marches to its own drummer, or rather to many drummers, as it processes information from millions of investors about whether they want to buy or sell a stock.

Earlier this year when US Equities were down 10% many thought this was the first sign of impending doom for the economy. Well, we all know what happened.  By the end of the quarter, the market had recovered from losses and entered positive territory. Although the economy is not without some areas of concern, it turns out wages are rising, corporate profits continue to be healthy, and inflation remains tame.

But if anything could shed light on the future of the economy, wouldn’t the stock market be the most logical place to look?  Shouldn’t we be able to check a benchmark index like the S&P 500, which has come to define the US stock market, and gain some helpful insights?  No, says Julieta Jung , PhD in Economics, who does research to inform policy makers and aid discussion at the Dallas District of the Federal Reserve.

Ms. Jung points out in a recent Economic Letter to the Federal Reserve Bank of Dallas that Indexes such as the S&P 500 are flawed mirrors of the economy and therefore fail to predict GDP. She notes that half of the components in the S&P 500 are manufacturers but when you look at US GDP, service providers account for more than ¾ of GDP output. Also, the stock market and the economy react very differently to shocks. The market can turn on a dime when unanticipated news or events occur until investors digest what has happened. In contrast, households and businesses adjust to the same news much more slowly.

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So what is an investor to do if she is uncertain about the direction of the economy and not sure if it is a good time to invest? First, understand that the stock market is not the economy and there is no reliable signal that can tell you it is a good, bad, or indifferent time to invest. Second, understand that your portfolio needs to be designed to match your tolerance for risk so you can stay invested through the inevitable ups and downs. Third, and most important, do what we constantly tell our clients to do- -focus on things you can control. We can’t control what the market will do but we can exert some control over certain things such as costs, taxes, investment discipline, and portfolio allocation. Our advice: Focus on these areas that will have a meaningful impact rather than on trying to decipher market gyrations.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.