Are You Too Smart to Be Rich?

The headline may sound ludicrous, but we’re serious.

We’ve learned all our lives that smart equals rich. Think back to the person in your high school designated “Most Likely to Succeed.” If the word “Dux” didn’t come to mind, we’d be surprised.

But there is a mountain of evidence suggesting that being extra smart won’t make you extra rich.

How the big boys fared…

Repeatedly, at the highest levels of finance, we’ve seen that smart doesn’t necessarily equal riches.

The collapse of all-star hedge fund Long-Term Capital Management gave us one object lesson. Despite boasting two winners of the Nobel Prize in Economics, the fund blew up in the late 1990’s — requiring a massive bailout by just about every Wall Street heavy hitter, including apparent bluebloods Goldman Sachs and JPMorgan.

We saw another object lesson just a few years later in the collapse of Enron — the supposed “smartest guys in the room.”

And more recently still, we saw stupid moves of investment banking “whizz-kids” threaten our entire financial system.

It ain’t just the big boys…

But just because none of us are running hedge funds doesn’t mean the same principle doesn’t apply to us.

Economist Jay Zagorsky ran a study to determine whether brains translate into riches. His conclusion? “Intelligence is not a factor for explaining wealth. Those with low intelligence should not believe they are handicapped, and those with high intelligence should not believe they have an advantage.”

In his book Outliers, Malcolm Gladwell explored example after example of how the successful became so. He concluded that “once someone has reached an IQ of somewhere around 120, having additional IQ points doesn’t seem to translate into any measurable real-world advantage.”

Billionaire investor Warren Buffett seems to agree: “If you are in the investment business and have an IQ of 150, sell 30 points to someone else.”

Is stupid the new smart?

You may notice a disconnect here. Those people quoted above are both extremely smart and pretty rich — including the most successful investor of our time. Yet they all seem to be saying that super-high IQs don’t help you become rich.

Where’s the gap? One word: arrogance.

It wasn’t excess brains alone that sunk Long Term Capital Management, Enron, and the rest of the investment bankers.

It was excess arrogance about those excess brains — believing that because they were smart, they could do no wrong and anyone who questioned them just didn’t get it.

How to avoid disaster

There’s a clear lesson from all this: invest humbly.

Specifically, it’s a reminder to know what you know and don’t know — which means abiding by Buffett’s concept of the circle of competence. In other words, you should only make individual share picks in areas where you have a competitive advantage.

A few examples:

In the technology space, can you predict which incumbents can innovate and fortify their moats? Can you pick the one or two long-term winners from the hundreds of new start-ups?

In banking, can you wade through the incomprehensible-to-most-pros financial statements of a National Australia Bank (ASX: NAB) or a Macquarie Group (ASX: MQG) to properly assess risk?

In energy, do you have a good grasp of the political and supply constraints on oil providers, and the definitions of terms like crack spread and grid parity?

Once you identify your circle of competence, remember that the folks at Long Term Capital Management, Enron, and Wall Street thought they had things figured out, too.

Stay humble, Foolish friends.

This article, written by Anand Chokkavelu, was originally published on Bruce Jackson has updated it.

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