Solving the Most Difficult Problem in Finance
It was considered the hardest problem in antiquity. Every man, woman, and child that had attempted to solve it before had failed. However, Alexander the Great was determined to succeed. Why? As the legend stated, the one who could untie the Gordian Knot would be the ruler of all of Asia. This was music to the young, power hungry ruler’s ears. However, there was still one problem — the Gordian Knot was believed to be the most complex knot ever tied.
The story goes that Alexander tried over and over again to untie the famed knot to no avail. After struggling for some time, he realized that no amount of thinking or analysis would help him solve the problem. As a result, Alexander unsheathed his sword and cut the Gordian Knot in half with a single slice. Afterwards, as stated in the prophecy, he went on to conquer the rest of Asia.
The legend of the Gordian Knot has a powerful lesson for investors about the importance of behavior over reasoning in financial markets. The idea is simple: Your actions will be far more important than your intellect over your investment lifetime. Your behavior will matter more than your fees, asset allocation, or your analytical abilities because it only takes one bad choice, one mistake to undo years of good financial decisions.
Don’t get me wrong, pure analytical approaches to investing have worked well for many, especially in the past. You only need to look at the investment records of Ed Thorp, Jim Simons, D.E. Shaw, and Cliff Asness, among many others, to see this. However, while superior intellect might seem like a solution to the problem of investing, it is far from it. For every Jim Simons success, there is a Long Term Capital Management failure. Today, those who have tried using machine learning are having trouble outperforming the market. A room full of PhDs can’t necessarily beat buy and hold.
This brings me to what I consider to be the most difficult problem in all of finance. No, I am not talking about the stock market. I consider that problem unsolvable for a variety of reasons. The most difficult problem in finance is yourself. The Gordian Knot is your mind. As Benjamin Graham, the famous value investor, once said:
The investor’s chief problem — and even his worst enemy — is likely to be himself.
This is why I often write about motivational topics on Of Dollars And Data, why I recommend books like Discipline Equals Freedom, and why I try to relate to my audience by discussing my own mental shortcomings. I am trying to get you to understand and control your own behavior. THIS IS IT. All the low cost index funds in the world can’t save you for your own psychology. They cannot make you hold when the markets are down 30%+. They cannot, as Michael Batnick said, “insulate yourself from yourself.”
Think of it this way: If you can’t avoid a sugar cookie (or some other temptation), how are you going to avoid the flood of fear and greed that will inevitably consume almost every person you know throughout your investment life? Don’t get me wrong, this won’t be easy. Even the experts can’t stick to their own financial advice. But, by realizing that you are your biggest challenge, you can start the journey of conquering yourself.
I have found it helpful to think of my life as if it were a game in which each problem I face is a puzzle I need to solve. By solving the puzzle, I get a gem in the form of a principle that helps me avoid the same problem in the future. Collecting these gems continually improves my decision making, so I am able to ascend to higher and higher levels of play in which the game gets harder and the stakes become ever greater.
Just like Dalio, you will need to face the game of life alone. Because only you can change the person you see in the mirror everyday. Only you can rewrite the story that you tell yourself about yourself. And if you succeed, you will become a better investor and an improved you. It’s okay if you stumble, we all do. But, can you keep going? Can you summon the will to defeat yourself? Can you cut the Gordian Knot inside your mind?
Willpower and the Oracle
Many people attribute Warren Buffett’s success to his intelligence, but I think his willpower may have had an even larger impact. Consider one of Warren’s bleakest times in the late 1990s when he went through a bout of underperformance. Buffett was mocked in the press and ridiculed as an out of touch old man. He was underperforming the S&P by 40% at one point, but managed to stay the course and eventually outperformed.
Imagine the will it took to do this. Imagine underperforming by 40% and having others think you had lost it. That’s where Buffett’s behavior proved far more important than his intelligence. But, you don’t have to believe me. Take the words directly from the Oracle of Omaha himself:
Temperament is more important than IQ. You need reasonable intelligence, but you absolutely have to have the right temperament.
Thank you for reading!
This is post 58. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data