How to become a successful investor: the psychological traits you need to develop

September 10, 2020

Have you ever wondered who an investor really is?

The simplest definition I found is "somebody who invests his/her money".

However, this definition doesn't take into consideration many important traits that can define an investor.

Based on my experience, there are 5 psychological traits that you need to develop and nurture if you want to be a successful investor.

The most successful investors in the world possess them and they can also be developed by a non-professional investor.

These 5 traits are:

  • Curiosity
  • Flexibility
  • Probabilistic thinking
  • Self-control
  • Risk management

Let's see them in more detail.

1. Curiosity

In the last years, I listened to a lot of financial podcasts where great investors were interviewed.

I read financial papers and financial books which were studying in detail the best investors of the last 50 years and I noticed that all these people are (or were) curious.

I couldn't find one that wasn't always looking for more information to absorb.

For example, Charlie Munger, Warren Buffett's legendary partner, has been described by his own sons as a living book.

Warren Buffett himself is no exception.

He gave a well-known piece of advice for those who want to become like him.

Read 500 pages a day of financial reports and trade journals, and do that for many years.

Ray Dalio, another investing legend, often talks about curiosity as one of the weapons that allowed him to succeed.

The (few) investors who managed to get great results in the financial markets are people who love to read, study, and absorb knowledge, not only investing-related.

They talk to people in different fields and try to understand new things.

Having a good knowledge of the investment world will give you everything you need to invest profitably.

However, if you want to take your understanding to the next level, you need to become curious about everything related to the business world.

Every time you buy a product as a consumer, ask yourself, "How is this company making money?

You'll discover that it's not always so obvious and you'll learn a lot of interesting things along the way.

For example, did you know that cinemas make a lot more money on popcorn than on the tickets?

There is also another way to feed your curiosity: read a lot.

As Charlie Munger says:

I've never met a wise person who didn't read a lot. None.

Reading provides you with a pair of glasses that allow you to see the world from different perspectives.

It is also magic, because it can become a microscope or a telescope according to what you need in a given moment.

Reading a bit of everything will help you develop a broad, yet unique knowledge, that will allow you to see investment opportunities invisible to the rest of us.

If you want to start from investing, here is a list of books I personally curated on this topic.

And to feed your curiosity even more, do not stop only to a subject that interests you.

The biggest investors have borrowed ideas from other disciplines (such as physics and psychology) to apply them to their investment strategies and obtain extraordinary results.

That's what I keep doing in Simplinvest during my workshops.

I mix psychology, statistics, economy, and sociology to help you gather the necessary knowledge to invest your money with confidence (and in the right products, too).

2. Flexibility

When I was a child, I read a story about a bamboo and an oak.

The bamboo bent at every wind blow, while the oak stood solid and well-planted.

One day a strong storm came and destroyed the oak, but it couldn't do the same with the bamboo.

It saved itself by bending over and avoiding the worst part of the storm.

This story is a perfect example of flexibility, one of the most important qualities for an investor.

If you've already read some of my posts on my free Facebook Group, probably a question popped out in your head.

"But why? You keep saying not to change your investment strategy, even during the most critical conditions, and now you change your mind?"

Actually, you can be flexible and have a strategy to follow continuously.

Let me explain it better.

Imagine having an investment plan on a well-diversified ETF that invests in stocks.

If this fund should lose value (due to a global recession) your investment strategy shouldn't be changed.

A general market downturn can happen.
It is an event that was considered during the preparation of the strategy.

But if in a dystopian future shares become outlawed, there would no longer be any point in buying ETFs, unless you want to become a criminal.

I made an extreme example, I know, but it is to highlight an important concept.

When the conditions change, the final outcome of the decision you made can also change.

As the legendary investor Charlie Munger says:

When the facts change, I change my mind. What do you do?

You should apply this reasoning to your investing strategy.

Every time you make predictions, especially those which try to look into a very distant future, at some point you will have to make adjustments.

It is unavoidable.

Sometimes an external event could change your mind on how much you are willing to risk (like the Coronavirus), but very often there are less dramatic events that happen to you personally that force you to reconsider your choices.

Maybe an inheritance, or a career change.
Something very personal that impacts a lot your life.

If you have a well-defined investment plan and tomorrow morning you will receive a large sum of money from a relative that you don't even remember, the strategy you had until the day before is obsolete.

Now you have to look at it again and decide how to manage your new money.

Keeping a flexible mind allows you to take advantage of one of the basic principles of investing.

Earn even when you are wrong.

The reason why you decide to risk your money in the financial world is not to rub in your friends' faces how smart you were when you bought Netflix 10 years ago.

What you should want is to grow your capital and make the compound interest working for you.

That's why one of the questions you need to constantly ask yourself is:

"What would happen if I was wrong?"

Let me give you a practical example.

Over the past 200 years, stocks have been the engine of wealth in every financial portfolio.

They were the best performing asset class.

However, there have been times (even long stretches that lasted several years) when stocks have done worse than bonds or gold.

And nobody knows when there will be another similar situation.

That is why investing 100% of your capital only in stocks (or at least in a specific asset) is very risky, especially from an emotional point of view.

When the stock market collapses and you own only stocks, it will be very difficult to continue to be optimistic and keep the necessary coolness.

Especially if many of your friends don't invest in stocks and right now are not losing even 1 cent.

That's why it's so important to build a well-diversified investment portfolio that can deliver results even when our beliefs like "equities are the engine of a portfolio" are tested.

Making money (or losing very little of it) even when you are wrong: this is the real advantage of flexibility.

To be as flexible as possible, however, you will have to do something very uncomfortable.

Look for new ideas and facts that go against what you think.

Let's be clear: "Go against what you think" does not necessarily mean something negative.

Imagine one of your goal is to buy a house that costs 300,000 € but you decide to wait.

After a couple of years you find another property, identical, that costs only 200,000 €, and you decide to buy it.

You have shown flexibility and you have also saved 100,000 € on such a big decision.

To exercise even more your flexibility muscle even more, try being a devil's advocate.

Take an idea of which you really believe it is true and defend…its opposite.

In this way you will be able to see nuances that at first glance you missed and understand the risks that you may have underestimated at first.

By using these tricks you will be able to develop more and more your flexibility, adapting your investment strategy to every possibility.

Let's move to item number 3, probabilistic thinking.

3. Probabilistic thinking

What does it really mean to invest?

Some might say that it is putting money into something today and expect to sell it tomorrow, at a higher price.

But this definition also includes speculation, so it is not the best one.

A better definition of what is an investment is the one given by Ben Graham, the master of Warren Buffett:

An investment is an operation that, after being carefully analyzed, offers a guarantee of the capital invested and an adequate return.

This definition may seem strange to you.

How is it possible to look for a capital guarantee, when one of the first condition to accept is that there is no guaranteed capital?

To solve this paradox I will bring in the third element of the successful investor: probabilistic thinking.

Probabilistic thinking is a kind of superpower that allows you to quantify the uncertainty, always present when you invest, and to find a way to deploy your money where the chances of success are greater.

Let's see a practical example.

Look at these two tables below:


In these two tables, you can see how many times the returns of the MSCI World and MSCI Europe index (two of the most used indexes for the stock markets) have been positive and how many times they have been negative.

As you can see, when the time horizon is limited (a few months and a year), the chances that the return is negative are quite high.

From 5 years onwards the chances of having a positive return increase dramatically, until you have a situation where, after 20 years, you have never lost money (at least according to the data of the last 50 years)

This is a very practical example of how to calculate the odds before making an investment.

Knowing this table, you can easily guess why investments in well-diversified ETFs must last at least 5 years.

This way, your odds of losing money are significantly lowered.

However, doing this kind of work is not enough.

To make the best use of probabilistic thinking you need to add another dimension: the magnitude of an event.

Let's see it in a practical example.

Imagine receiving this proposal: there is an investment that has a 99% chance of having a positive outcome and putting 2000 euros in your pocket and a 1% chance of losing 200,000.

Do you think this is a good deal?

Although it is very unlikely to go wrong, you are actually exposing yourself to a huge risk for no reason.

And you can see how dangerous this investment is by calculating its expected value.

The formula to use is very simple.

Just multiply the end result of the investment by the possibility that it will occur.

In this case:

2,000*0.99 - 200,000 *0.01 = 1,980 - 2,000 = - 20 euros

This value is negative because the small probability of it going wrong has a huge impact on your financial situation, compared to the positive probability.

Unfortunately, in the real world the odds are never so clear.

If you want to determine how risky is an investment, you have to make an estimation of the probability.

Here is a practical example, with an estimation of the probabilities that I made personally.

Imagine that an ETF that invests in the well-diversified MSCI World index seen above, has a 95% chance of having a return of 4% per year or more and a 5% chance of having a return of -2%/year (a very pessimistic scenario, since it has never occurred so far).

All of this assuming a time horizon of 10 years.

In this case, the expected return is 4*0.95- 2*0.05 = 3.8-0.1 = 3.7%.

Even if I used very pessimistic numbers (a 4% return per year, when the historical average was 7%) and a 5% chance of final negative returns, (which never happened before) the final result is still very positive.

Especially in an era of low rates like the one we live in nowadays.

(Note: These are data that I used for educational purposes, do not focus too much on the final number.
The main purpose of this exercise is to make you realize that even in a situation more negative than those that happened so far, the risk of losing by investing in stocks with the right time horizon is very low).

So, how can you apply the same reasoning to any future investment?

Follow this process:

  1. Look for as much historical data as possible on the investment you want to make;
  2. Using historical data, assign a % of success and failure to your investment (do not be afraid to be conservative);
  3. Calculate the expected return and decide if it is worth it, considering also the worst possible case

This process is not infallible but using it continuously you will avoid the biggest mistakes.

4. Composure and control

Why you want to invest?

I'm not talking about generic stuff like "having more money", but the deeper reasons why you want to do it.

For example:

  • A better future for you or your children.
  • Investing to get the money for the business plan that's been buzzing in your head during the last year
  • Buy you the house of your dreams

Knowing the real reasons why you invest is the first step that will allow you to acquire one of the most important superpowers to become a successful investor: self-control.

Many of the people I know invest without a specific reason.

They just want to make some extra money in the financial markets.

As soon as things get bad, they panic and sell, lose money, and swear they will never invest again.

Without a clear goal, they have given in to the first difficulty.

Those who invest by objectives (like all Simplinvest clients) know very well that each objective requires different financial instruments, depending on when and what needs to be achieved.

Using this approach, called Goal-Based Investing, you will have the self-control you need to manage your declines and know what to do in every situation.

5. Risk Management

Try to think back to the most beautiful and memorable moment in your life.

Maybe it was when you met your soul mate.

Maybe it was when a chain of events led you to your dream job.

Whatever you have in mind now, I'm sure you had to risk something to get it at some point.

And this brings us to the fifth point: risk in financial investments.

Risk is an unavoidable element in our lives, we can't eliminate it.

Even in the smallest and most harmless activities, there is a risk that something will go wrong… or it will be much better than expected.

For this reason, asking for 100% guaranteed capital and seeking total security makes no sense.

It does not exist.

In the financial world, by convention, the rate of return on government bonds is called "Risk-Free".

Yet if the state fails (like Argentina or Greece) it turns out that government bonds are also risky.

And the states that are more financially solid offer very low or negative returns.

Data from from 10/09/2020

Today more than ever, risk cannot be avoided when investing.

And it is even more important to understand how much risk you can take and how to do it in the best possible way.

All great investors have a risk control system in place.

Warren Buffett, for example, uses a margin of safety.

Before making an investment he makes an estimate of how much it might be worth in the future and then uses mathematical formulas to calculate the current value of the investment (also called intrinsic value).

If this value is much higher than the current price of the product in which he wants to invest, he buys it, otherwise he does nothing and waits for a better opportunity.

This is drastically reducing the chance of losing money.

Even if Buffett should have made some mistakes during the evaluation phase, for example been too optimistic, he will still have the possibility to earn something, even if he was wrong.

Other investors with more speculative styles, instead, use the stop-loss mechanism.

When certain conditions change, or the price falls below a pre-determined level, they decide to close their investment and preserve their capital.

These are just two examples of risk management, but they are not the best for a non-professional investor, especially if he is only buying ETFs.

In this case, it is much more important to determine what type of risk you want to take.

First, you must decide if you are willing to accept a total loss of the capital you are investing or not.

Understanding this is essential to understand how much money you are willing to invest in the most speculative way possible (it should never be a lot, anyway).

Once you have done this, you need to understand how much you are willing to see your investments' value fluctuate.

In this case, it is much better to think about absolute values rather than %.

Having a temporary loss of 50% of your invested capital may seem enormous.

But if you have invested 5,000 euros and your net worth is 300,000 euros, it shouldn't worry you very much.

When you have found the value of the temporary loss that you are willing to accept…test it!

A lot of people say they are very tolerant of risk when the financial markets go up and then sell out of fear when they go down.

The longest you invest, the more accurate you will be in predicting the level of fluctuation you are willing to tolerate.

And it will be easier for you to stay the course and continue to follow your investment plan, even when the situation looks critical.

How can you better manage the risks of investing?
Here are 2 ideas:

1.Have a designated amount of money dedicated to paying your bills for at least 6 months, including emergencies, and scheduled purchases.

It will help you stay calm when you see your investments swing dangerously.

  1. Rebalance your investments every year.

Rebalancing is a concept a bit more advanced and it could be scary for a non-professional investor.

In a nutshell, rebalancing means to divide your investment portfolio in % according to the different financial products you bought, and make sure that after a period of time (usually one year), the % are still the same.

If they are not the same (it's usually the case) you buy and sell accordingly, to go back to the same %.

In this way, you make sure that you are taking only the risk level that you are willing to tolerate.

And with this one, we finished for today.

It was a long article but you can use it as a reference to become a successful investor.

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