Can You Banish The Irrational Investor In You?

Are you an irrational investor?

This might seem like a mean question, but please do not be offended.

The area of investment and portfolio management has been investigating - virtually non-stop - the results of rational decision making. It does not need a genuis to explain that making financial decisions logically should result in higher profits and lower losses.

This, therefore, is something of a holy grail to professional investment managers.

However, it turns out that vast numbers of private investors are not able to manage money in this way. This may seem contrary to logic, but it is true.

Luck As An Investment Strategy

Merton Miller, a defender of rational theory in investment, and a Nobel Laureate at the University of Chicago, once said about investors who do not use professional advisers:

"For these investors, stocks are usually just more than abstract 'bundles of returns' of our economic models. Behind each holding may be a story of family business, family quarrels, legacies received, [and divorce settlements] ... almost totally irrelevant to our theories of portfolio selection."

In other words, for many investors, they are themselves the enemy of rational investment decisions and superior performance and returns. This was not said to ridicule or admonish, simply an effort to state the reality.

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As a former investment consultant, your author has met a number of people that had inherited a portfolio of stocks. They personally had no real interest in investment or being a stock market investor and barely even knew the names of the holdings they had, even less the actual businesses they were operating. Yet, they felt compelled to hold on to these positions out of loyalty to their deceased relative. As understandable as this may be, at the same time, these people had mortgages and debts and interests that could have been enhanced by the use of the money.

Learn To Think Like The Best

Possibly the most highly regarded rational mind in the world of investment is Charlie Munger. Munger is a lawyer by training but has been the investment partner of Warren Buffett for decades. He often describes many of the mental models he uses to help him make fast and accurate decisions in business, investment and life. Buffett often describes him as having the best 30 second mind in the world.

Another very famous mind of equal rationality is George Soros, of hedge fund and democratic philanthropy fame.

Financial Mathletes

However, in the modern world of investment banking and hedge funds, there are 'quants everywhere. These are mostly physicists and mathematicians - usually known as quantitative analysts - whose job it is to study markets for patterns and write algorithms to take advantages of any small mispricing they see. In other words, these are very logical people!

Their work is often very secretive and extremely well paid because of the ability to generate money that their trading strategies have.

As an example, in his very enjoyable book "The Quants", Scott Patterson describes one of the most successful quant hedge funds, PDT inside Morgan Stanley. He writes, "Morgan Stanley won't reveal precisely how much money PDT made over the years, but former employees commonly characterize it's profitability as off the charts. For the ten years through 2006, PDT churned out an estimated $4 billion in profits, after shaving 20% off the top, which the company paid to members of PDT. That means that a small group of traders during that time took home roughly $1 billion. The salaries of the top brains at PDT such as Muller, Nickerson, and Ahmed in some years vastly exceeded the take-home pay of top executives in the firm, including the CEO."

If these are not great examples of the benefits of being a rational rather than an irrational investor or trader, it is difficult to know what else is...

The question is, what are the next steps? Needless to say, an improving understanding of mathematics would be very helpful. Game theory and decision trees ought to be interesting theories to learn about to help develop thought processes. Other potentially interesting areas to delve into are the workings of the mind such as mind mapping and lateral thinking. If sufficiently interested, these are fascinating areas to research and learn about - on one level, the workings of the world are contained within them.

Other pages that may be of interest to this subject include:

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How To Find Great Stock Trading Courses

Stock Trading For Beginners

Why Use Stock Market Programs?

Should You Be Investing In Stock Market Assets?

Does Automated Stock Trading Software Work?

Why Do So Many Stock Market Traders Go Broke?