Not everyone has the same success in the stock market. Some investors clearly stand out for their ability to make significant profits over time. So what separates these highly successful investors from the rest?
There are many ways to be a good investor, but there are a handful of things that many of these great investors have in common. These traits fall into three broad categories:
- The right temperament
- The ability to value assets
- An appropriate understanding of risk
By developing these traits, you can increase the odds of becoming a good investor and reaching your financial goals, just as an athlete does by training in a gym.
- Three things good investors have in common are the right temperament, the ability to value assets and businesses, and a keen understanding of risk.
- In order to cultivate these traits, investors can use the "mental model" approach to help them avoid making poor investment decisions.
- The mental model approach involves understanding such concepts as cognitive bias and information symmetry. Knowing these things can help you make decisions based in fact and not feeling.
The Right Temperament
When it comes to investing, disposition may be the biggest difference-maker. Temperament is different from knowledge, intelligence, wisdom, and discernment. Investors need patience. In the words attributed to famed investor Warren Buffett, "Some things just take time; you can't produce a baby in one month by getting nine women pregnant."
To be a great investor, it's important to be able to tune out the noise and stick to a plan while ignoring the crowd. You need a firm grasp of financial history to know what works—for example, buying assets for less than they are worth at attractive discounts to net present value (NPV) and then holding to collect the dividends and interest income. You need to have the fortitude to remain steadfast.
During the 1990's dot-com bubble, some of the best investors in the world who refused to give in to the insane stock prices of the time—thus appearing like "dinosaurs" and "old men"—were sent letters asking if they were waiting for the second return of Elvis. The moral of their story? Don't be swayed by public opinion.
Investors also need the emotional capacity to separate normal market fluctuations from the underlying real value of an asset. If you bought an apartment building in your hometown that generated $50,000 per year in passive income from rents and someone offered to buy the place for $100,000, or twice your earnings, you'd likely ignore them or laugh in their face. Yet, when the same thing happens in the stock market, many people are apt to panic and accept the deal. It's hard to get rich doing that.
The Ability to Value Assets and Businesses
If you've researched stocks at all, you know it is vitally necessary to possess the ability to calculate the intrinsic value of an asset. It doesn't matter if that asset is a car wash, a government bond, a share of stock, a dry cleaning business in your hometown, or an international hotel conglomerate. Unless you can pull out a calculator and run the formulas yourself, you are always going to be operating at a significant disadvantage compared to the great investors.
At first, the math can seem daunting and downright confusing. But continually remind yourself that all you are trying to do is answer one question: "How much should I pay for $1 of net present value earnings?" You'll be surprised how this simple mantra will keep your thought processes clear. The answer to that question can mean rejecting 90 or 95 out of 100 investment opportunities, but remember this: it only takes a handful of good decisions to get rich or reach financial independence.
Calculating NPV is one of the simplest ways to compare the value of assets over time. When comparing two potential investments, the one with the higher NPV is the better choice.
An Appropriate Understanding of Risks
It's believed that Mark Twain said, "History doesn't repeat but it does rhyme." There is, perhaps, no better preparation for managing money and building your net worth than a firm grasp of financial history. There wasn't a fundamental difference between the real estate bubble, the dot-com craze, and the Dutch tulip bubble a few centuries prior. By arming yourself with an understanding of history and human psychology, you can improve your understanding of risks and increase your chances of avoiding mistakes that could hurt your family's well-being.
One avenue you can take is the "mental model" approach. A mental model is an idea or concept that is used as a tool to help you avoid making poor decisions. Mental models include things such as:
- Horn and halo effects: types of cognitive bias
- Veblen goods: a paradox of supply and demand
- The illusion of choice: a model of human happiness
- Information asymmetry: a transactional model
It may not be evident at first why these concepts are important to business and investing, but studying them, adjusting for them, and putting them to work in your own endeavors can help you become a good investor and grow your bank balance year after year.