How much expertise does it take to be a Cognitive Investor?

This is a follow on essay to the two blog articles, “How much time does it take to be a cognitive investor,” parts one and two.  If you have not read those articles, I recommend reading them first.

The short answer to how much expertise is required to be a cognitive investor is, “less than you might imagine.”  There is a close analogy to the answer how much time it takes.  As long as one focuses on the relevant elements that can really make a difference and does not get distracted by studying topics that have little bearing on investment results, the amount of expertise is easily within the grasp of almost anyone capable of graduating from college.

The required expertise falls into four general categories: finance, mathematics, psychology, and process.

A minimum of finance literacy is required.  One needs to fully understand basic investment concepts such as stocks, bonds, mutual funds, stock exchanges, indexes, interest, dividends, taxes, and inflation.  These are the fundamental building blocks involved in the portfolio management process.

The second area requires a dollup of mathematics.  Investing does not require knowledge of stochastic calculus or even advanced algebra, but it does require a thorough understanding of some elementary operations like percentages and ratios.  A rudimentary understanding of basic probability and statistics concepts is also very handy.

The third category, psychology, is probably the most overlooked and poorly understood area that investors need to better comprehend.  Warren Buffett’s teacher, Ben Graham, said that, “The investor’s chief problem—and even his worst enemy—is likely to be himself.”  If one is to be a successful investor, one needs to understand how intuitive psychological urges lead to counterproductive investment decisions.  This theme is thoroughly explored in the book, Cognitive Investing.

The fourth category is that of process.  This is also a neglected topic.  What is presented to many investors as investing is really gambling.  Understanding the difference between investing and gambling is critical.  Should the process be dependent on accurately being able to predict the future?  Where should one go for unbiased, helpful information?  Focusing on developing a sound decision-making process, rather than dreaming about the potential results of an ad hoc process will lead to far better outcomes.

An investor with sufficient knowledge of these four subject areas can become a successful cognitive investor and reap its many benefits.  Notice that economics is not included in this list.  Knowledge of economic principles and concepts is not going to hurt, but it can be more of a distraction than an asset.  The core idea behind cognitive investing is to focus on what really makes a difference in results and to understand what causes the typical mistakes preventing many investors from reaching their goals.  In depth knowledge about economics is not going to help if psychology and process are ignored.  Accounting is similar to economics in that knowledge in the discipline is not going to hurt and could be useful, but it also can distract one from focusing on the more critical disciplines.  If proper perspective is maintained, then there is no problem learning about these topics.  But they are not required for investing success.

The bottom line is that the level of required expertise should not be a stumbling block. It is not rocket surgery.  Openness to new ideas and willingness to change entrenched behavioral habits will likely present more of a challenge than the ability to understand the concepts.  The concepts are straightforward.  The implications of the concepts may require a magnitude of change that forces the investor to face an uncertain future.  This fear of change is uncomfortable and thus creates a barrier to concurrence.  And concurrence is essential before implementation can go forward with any reasonable chance of long-term success.

So how does one go about gaining the necessary expertise?  Reading Cognitive Investing is an excellent first step.  But in most cases, it will not be enough.  Understanding the concepts is one thing.  Putting them into practice is another.  The latter requires concurrence with the former.  And then it requires the diligence to take the necessary actions to put them into practice.  If you are unsure about how to apply cognitive investing principles to your own situation, perhaps one of the programs described on this web site (click on the “Programs” tab) will help.  It could be the most profitable investment you ever make.

  1. #1 by Don C. on April 4, 2012 - 7:09 pm

    Rich,
    The basic principle of your book, as I understand it, is to invest in uncorrelated securities and periodically rebalance them. We can’t know which investments will go up and which will go down. But it really doesn’t matter as long as, over the long run, the investments make uncorrelated “up and down” fluctuations. Rebalancing will force you to sell high and buy low.

    I believe in this principle with one reservation. If a particular class of investment is already “pegged” at one extreme of its viable range (that is, it is up against some fixed limit), then that investment can only move in one direction. For an example, consider long-term bonds, which are sensitive to interest rate. The Federal Funds Rate is approximately zero, which means it can only go higher. Therefore, for now, long-term bond prices can only go down, not up. In order for bonds to fluctuate “up and down” to generate rebalancing opportunities, interest rates need to be higher than zero, to give some room on the “up” side.

    It seems to me that long-term bonds can play an important role in a rebalancing strategy when the Federal Funds Rate is in a “normal” range–at least, greater than zero. This gives bond prices room to move in both directions. But for now, there’s only one way they can go. Therefore a wise investor would not invest in bonds until the Funds Rate rises a little.

    I expect that you will disagree with this, and I would be interested to learn why.
    -Don

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