How Emotional Intelligence Can Make You a Better Investor

March 19, 2015 in Process
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Your knee hurts, so you pay a visit to your favorite orthopedist. He smiles, maybe even gives you a hug, and then tells you: “I feel your pain. Really, I do. But I don’t treat left knees, only right ones. I find I am so much better with the right ones. Last time I worked on a left knee, I didn’t do so well.”

Though many professionals — doctors as well as lawyers, architects and engineers — get to choose their specializations, they rarely get to choose the problems they solve. Problems choose them. Investors enjoy the unique luxury of choosing problems that let them maximize the use of not just their IQ but also their EQ — emotional intelligence.

Let’s start with IQ. Our intellectual capacity to analyze problems will vary with the problem in front of us. Just as we breezed through some subjects in college and struggled with others, our ability to understand the current and future dynamics of various companies and industries will fluctuate as well. This is why we buy stocks that fall within our sphere of competence. We tend to stick with ones where our IQ is the highest.

Though we usually think about our capacity to analyze problems as being dependable and stable over time, it isn’t. It might be if we were characters from Star Trek, with complete control over our emotions, like Mr. Spock, or who lacked emotions, like Lieutenant Commander Data. This is where our EQ comes in.

I am not a licensed psychologist, but I have huge experience treating a very difficult patient: me. And what I have found is that emotions have two troublesome effects on me. First, they distort probabilities; so even if my intellectual capacity to analyze a problem is not impacted, my brain may be solving a distorted problem. Second, my IQ is not constant, and my ability to process information effectively declines under stress. I either lose the big picture or overlook important details. This dilemma is not unique to me; I’m sure it affects all of us to various degrees.

The higher my EQ with regard to a particular company, the more likely that my IQ will not degrade when things go wrong (or even when they go right). There is a good reason why doctors don’t treat their own children: Their ability to be rational (properly weighing probabilities) may be severely compromised by their emotions.

A friend of mine who is a terrific investor, and who will remain nameless though his name is George, once told me that he never invests in grocery store stocks because he can’t be rational when he holds them. If we spent some Freudian time with him, we’d probably discover that he had a traumatic childhood event at the grocery store (he may have been caught shoplifting a candy bar when he was eight), or he may have had a bad experience with a grocery stock early in his career. The reason for his problem is irrelevant; what is important is that he has realized that his high IQ will be impaired by his low EQ if he owns grocery stocks.

There is no cure for emotions, but we can dramatically minimize the impact they have on us as investors by adjusting our investment process. First and foremost, investors have the incredible advantage of picking domains where they can remain rational.

For instance, I would not be able to keep a cool head if I owned gold. I can recite the arguments for and against gold (lately, with negative interest rates in certain European countries, the “for” arguments have started to make even more sense). But, intellectually, I cannot reconcile the fact that gold is an asset that generates no cash flows, and thus to me it has no financial center of gravity. I have no idea what it is worth. The very idea of owning gold bothers me, and therefore I know that if I did own it, my EQ would be low. I’d be buying high and selling low. But as a value investor, when I buy a stock and it declines 30 percent, I want to buy more of it (assuming its business has not changed). I wouldn’t trust that I could do this in the gold market.

To be a successful investor, you don’t need Albert Einstein’s IQ (though sometimes I wish I had Spock’s EQ). Warren Buffett undoubtedly has a very high IQ, but even the Oracle of Omaha chooses carefully his battles; for instance, he doesn’t invest in technology stocks.

Investors have the luxury of investing only in stocks for which both their IQ and EQ are maximized, because there are tens of thousands of stocks out there to choose from, and they need just a few dozen.

Meanwhile, I hope when I go see the doctor, he will tell me, “I don’t do left knees,” because the best result will come from a doctor who while treating me will utilize both IQ and EQ.

Originally published on Institutional Investor… 

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