I want to continue on this theme of "cocaine brain" for a little bit because I think it can explain how a judgment-based manager can lose all objectivity. . .

Several years ago, I was listening to a very successful fund manager talk about his portfolio. Let's call him Will. Will was telling me and a few other colleagues about how well his portfolio was doing, especially two stocks that were performing exceptionally well. As he explained it, he initially estimated he'd make 5x his money on these stocks, but as it turns out, he was wrong. Over a period of several years he made 30x his initial investment on the two stocks. When Will told this story, everyone laughed. Will attributed his outstanding performance to the notion that he and his team were much smarter and worked much harder than everyone else. So they deserved to do better. Right?

Wrong. Notice a couple things here. First, Will initially thought he'd make 5x his money on the two stocks, but instead, he made 30x his money. He misjudged the price of the stock by a magnitude of 6! It's not like he thought the stock would trade at 50 and it went to 60 and he missed by 20%. Will missed the magnitude of the move by a huge margin! Therein lies the important revelation that he overlooked. Will is really bad at forecasting stock prices!

Okay, I know what you're saying: "Hey, I'd be delighted if my manager made that kind of mistake!" But let's look at it from another perspective. Suppose an economist says inflation will increase to 3% over a period of time, and instead it increases to 18%. Same magnitude of mistake. Would you want to use that economist?

But notice how Will's brain works. He doesn't say, "Wow, I really missed the mark on that stock. I was lucky it moved in the right direction. I should be more careful about risking my client's money going forward." No, he says, "I'm a brilliant portfolio manager and I will keep looking for other stocks that have the potential to appreciate 30x."

Remember when you buy a stock that does this well and you attribute it to your fantastic judgment, it can release endorphins in your brain that cause intense emotional pleasure. Just as winning at craps can cause a great deal of excitement and adrenaline in a gambler, the same pleasure centers in the brain can be stimulated by a winning investment.

Will got a tremendous amount of positive publicity and accolades as a result of the stellar performance of those two stocks. Unfortunately, all of this attention made it highly difficult for Will to be objective about his own ability going forward. Eventually, his fund performance lagged badly. I think if he hadn't had such an amazing run in the 90's, he would have done much better in the 2000's. Part of his problem was major overconfidence in his own ability. This may have been compounded by a natural desire to rescue his fund by identifying additional stocks that would eventually produce huge returns.

Naked strategies help investors avoid all of this messy emotional thinking. I never get all that excited about a stock that does extremely well because it was selected based on rules. After all, I can't attribute that stock's performance to my brilliant judgment. I attribute it to simply following a set of rules that have been created to maximize performance and expecting that because of the law of averages some of the stocks will do very well.