What differentiates an investor who makes good investments from one who makes questionable ones? If one goes by what the financial-services industry believes in, then the answer is nothing. There is no inherent difference. Anyone who listens to the right advisors, absorbs the knowledge doled out by financial-product companies, reads about and researches financial products can make good investments.
But people like me, who interact with a huge number of investors, find it easy to believe that there is something inherent about the qualities that make some of us better investors. Often, it appears that those who repeatedly run after questionable investments do so because of some characteristic of their personality.
A few days ago, I read an article that made me think hard about whether this was really true. This article, which was on the fascinating Brain Pickings blog, summed up some pretty interesting research into the psychology of learning. The article is called Fixed vs. Growth: The Two Basic Mindsets That Shape Our Lives. What attracted me to it first was the phrase 'Fixed vs. Growth' but as it turned out, the words did not mean what they do in finance and investing.
What they meant was a 'fixed mindset' vs a 'growth mindset'. Surprisingly, the researchers found that a fixed mindset is more commonly found in people who have an inherent ability or intelligence. They start out trying something and succeed at it without much effort. Then they try something harder and fail, and often regress, limiting themselves to whatever they first succeeded at. They tend to shy away from harder things.
On the other hand, those who didn't have an inherent ability actually progress further. They try something but succeed only with hard work and dedication. This gives them a valuable life lesson - that effort and hard work bring success. They learn that if something is more difficult, that doesn't mean that it's undoable. It just means it will take higher persistence and a more sustained effort.
By now it should be obvious that this has profound implications on investing. Many of us try non-optimal, low-return investments and find comfort in their predictability. Then, we try some equity or equity mutual funds and find that the going is not so easy. Sometimes, there are setbacks. But when setbacks hit, different investors react in very different ways. Those with a growth mindset conclude that they didn't do something right and set forth to fix it. Those with a fixed mindset decide that equity doesn't work and retreat to the counterproductive world of fixed deposits and similar products.
In a way, fixed and growth mindsets have a parallel in the world of investments. There are investors with an equity mindset and there are those with a fixed-income mindset, and members of either group are psychologically incapable of defecting to the other. If you get a debt person to invest in equity, the uncertainty and the stress of the market's gyrations makes him run away sooner or later even if he appreciates the logic of investing in equity. And equity people consider all debt investments to be a waste of time or money. It goes without saying that one needs to balance the two sides, but unless one has a learning-and-evolving mindset, it can't happen.