klementoninvesting

Friday posts are always more on the quirky side of finance and sometimes just a pure WTF moment. One such moment occurred when I read a paper by Chao Ma from Xiamen University, who investigated the behaviour of Chinese drivers. Personally, I am a pretty careful driver who has not had an accident in almost 15 years and who is obsessed with keeping his premium discount for accident-free driving. In most countries, and this includes China, drivers get a discount on their car insurance for driving accident-free. 

Yet, human beings seem to be unable to remember this unless they are in the process of renewing their policy. The monthly insurance premiums are salient all the time, the discount only once a year. And this triggers the sunk cost fallacy. Towards the end of their contract, drivers are acutely aware of all the money they have spent on insurance without getting anything in return. So, in for a penny, in for a pound, they seem to say and start to drive more recklessly in the last month of their insurance contract. The chart below shows the number of accidents by policy holders sorted by the months since the policy has been taken. The WTF moment is obvious. The two spikes in accidents in months 12 and 24 just before the policy expires. The research indicates that about 2%-3% of all accidents by individual drivers in China are due to this sunk cost effect. Given that Chinese car insurers pay claims of about $69bn each year, this means that somewhere between $1.4bn to $2bn in annual accident claims may be due to drivers forgetting about their insurance discounts in China alone. As Albert Einstein once said, there are only two things that are infinite, the universe and human stupidity, but I am not sure about the former.

Rate of accidents sorted by month after the car insurance policy has been taken

Source: Ma (2021).

People who know me for a while know that I am a big fan of infrastructure investments. In particular, I like direct infrastructure investments, both green and traditional. Before I moved to the UK, I did not know about the large number of listed infrastructure funds in the UK that allow investors with every budget to invest in this asset class. Without endorsing any specific fund and reminding everyone to do their own due diligence before investing in any of these funds, you can get an overview of the listed closed-end funds in the infrastructure and renewable energy space at the homepage of The AIC.

But investors also need to be aware that infrastructure investments are not as straightforward as they might think. One of the most common reasons why investors want to get a hold of infrastructure assets is because they promise stable cash flows that often are linked to inflation. And in a yield-starved world getting a stable dividend of 5% or more is indeed very tempting.

But when you look at the actual performance of closed-end funds and direct infrastructure investments, then their cash flows look anything but stable and in fact resemble more the cash flows of traditional private equity and direct real estate funds.

Distributions of infrastructure funds, private equity and real estate over time

Source: Andonov et al. (2021)

A new paper explains why. The underlying cash flows from the infrastructure assets are indeed very stable, but they only make a small part of the total cash flows of the investment. The bulk of the cash flows are generated by selling existing assets and distributing the proceeds to investors, just like a private equity or venture cap fund would do.

Simulated cash flows of infrastructure funds

Source: Andonov et al. (2021)

In fact, the main explanatory variable for the difference in performance between a top quartile and a bottom quartile infrastructure fund is how well the asset manager is able to exit an investment at a profit within the first five years of the fund’s life.

As they say in investing, a successful investment requires two good decisions, the decision to buy and the decision to sell. So far, the decision to sell generally was quite easy to make. As more and more investors increased their exposure to infrastructure investments, there were plenty of buyers for existing assets. Exits were easy and prices achieved were high. But as the asset class matures, less and less new money will flow into it and exits will become harder to do profitably – especially if you have paid too much for an asset when you bought it. This will mean that returns for infrastructure funds will likely decline over time, just like they did for private equity and venture capital. And it will become more and more important for investors to do their due diligence and invest in high-quality asset managers that don’t overpay for assets.

I know we are debating in the United States and the UK when the central bank will stop buying additional government bonds but if we are honest, no one who should be taken seriously currently expects long-term bond yields to go through the roof. We will face several more years of very low bond yields compared to historical averages.

All of this is done to incentivise businesses to borrow money and invest it for future growth. And on average that is what low bond yields do, though to a much smaller degree than central bankers would like. But as the old joke goes, an economist is someone with his head in the oven and his feet in the fridge, saying “on average, this is quite comfortable”. 

The problem with low bond yields is that the impact they have on companies is very different. And once more, we can and should learn from Japan where we have more than two decades of low interest rates to teach us how business leaders take advantage of them.

One key driver of corporate behaviour with respect to long-term bond yields is the interest cover ratio of the company. Most companies (even in Japan) have an interest cover ratio (ICR) above one, that is their operating earnings cover their interest expenses and more. But there is a substantial minority of companies (in Japan it is currently about 15% of all businesses) that are zombie companies in the sense that their operating earnings aren’t sufficient to even cover the interest expense on their outstanding debt.

In an environment of low short-term and long-term interest rates, these two types of companies behave very differently. High-ICR companies with profitable businesses tend to take advantage of low interest rates and invest in future growth. While this may mean taking out loans in the short term, over time, the investment in future growth will create additional profits to pay back the outstanding loans and debt and delever the balance sheet. Meanwhile, low-ICR companies that can’t even cover their interest expense don’t invest. And rightfully so, because if you take out a loan to invest in an already unprofitable business, you are just making your situation worse. Instead, the best thing you can do is to replace short-term debt with long-term debt to lock in the low interest rates for as long as you can. As the two charts below show, this is exactly what happened in Japan. Profitable high-ICR companies invested in their business and reduced their debt over time, while unprofitable low-ICR companies just shifted short-term debt into long-term debt.

The impact of low long-term rates on corporate balance sheets. Short-term debt on the left, long-term debt on the right

Source: Igan et al. (2021)

In the long run, this increases the difference between zombie companies and profitable companies in several metrics. Profitable companies invest in future growth and create large amounts of shareholder value while zombie firms just shift debt from short-term to long-term and continue to slowly erode shareholder equity. Thus, paying attention to which company is able to cover its interest payments with its operating profits and which is not, is a key factor to understand if you want to invest in companies that will do well over the next five to ten years.

Change in balance sheet due to low interest rates

Source: Igan et al. (2021)

The Gamestop bubble at the beginning of this year has created an enormous amount of research by academics in recent months, much more than any other bubble in recent memory. By now we know that retail investors did not “win” against the big hedge funds. Just like I anticipated in January, there is no evidence that retail investors on average made money during the Gamestop episode or that the investment decisions of retail investors can be used to make money in stock markets.

The folks who participated in the Gamestop frenzy were essentially uneducated investors playing the lottery, were mad at Wall Street and overconfident in their ability to beat hedge funds at their own game.

In general, being stupid and overconfident is the best way to lose money. Heck, somebody once told me that the number one cause of death for young men between the age of 16 and 30 is stupidity. And yes, it’s mostly men, because young men think they have figured out the world and have way too much testosterone in their blood to think before they act – especially if they think they can express an attractive girl with their actions. Whether it is falling off a building while taking a selfie on the ledge of a skyscraper, fainting while holding your breath driving in a tunnel and then causing a car crash, or tying yourself to a shopping cart and then pushing the cart into a deep lake, young men are idiots. And if you are the parent of a teenage boy, you know I am right.

But going back to investing, stupidity paired with overconfidence can cause a lot of harm there as well. An analysis of retail investors tried to figure out who buys stocks on margin and who is likely to get a margin call. Turns out that two factors play the key role in determining which investors buy stocks on margin: financial literacy and overconfidence. The charts below show that investors with lower financial literacy are more likely to buy stocks on margin, presumably because they don’t fully understand the risks of buying stocks on margin. In the most extreme cases this can end tragically, as we have seen this year. The second driver is overconfidence. The more confident investors are in their ability to pick stocks, the more likely they are to use margin to boost their investments. Combine a lack of financial literacy with an abundance of overconfidence and you have: a young man making his first trades in the stock market and getting hammered. The best case outcome is that these losses from their investments are “school fees” to be paid as these young investors learn about how markets really work and that there simply is no easy way to get rich quick.

Financial literacy and overconfidence the key drivers of the use of margin

Source: Kim et al. (2011)

Note: This article was co-written with Michael S. Falk and first appeared on the CFA Institute Enterprising Investor Blog.

Climate change remains a key issue to solve in the coming decade. We say decade because any longer may already be too late. 

We all will have to pay a price for burning fossil fuels, but unfortunately the bulk of that price will not be paid by those who burn fossil fuels. It is a classic problem of a negative externality: The profits of an activity — in this case, burning fossil fuels to generate energy — are privatized, while the costs, to human health and the environment, are socialized.

In theory, we know how to deal with these issues. We can either regulate the activity, as President Richard Nixon did with the creation of the Environmental Protection Agency (EPA) to reduce air and water pollution in the 1970s. Or we can internalize the costs by putting a price on carbon credits or instituting cap-and-trade programs as is common across Europe and is now being introduced in China.

The problem with these approaches is that they are green sticks. They restrict freedom of enterprise and thus are, let’s say, not very popular with the companies that burn fossil fuels. But that does not mean we care about popularity as much as we care about incentives. Big Oil’s resistance to environmental regulation and carbon pricing in the United States has been enormous, though recent events at Exxon and Shell indicate that it may be losing the fight. 

Nevertheless, the current price of carbon emissions is generally too low, and is at best 50% of what it should be, according to estimates. Carbon emitters spend a lot lobbying to keep that cost well below the threshold required to encourage the fast and effective change that’s needed to avoid climate change’s worst outcomes.

But regulations will have to go even further than carbon pricing. Do we also need rules to help prevent and manage the risk of stranded assets? In a word, yes.

That got us thinking. . . . Instead of using green sticks to force change, why don’t we use green carrots to entice change? After all, these approaches are not mutually exclusive.

One way to introduce green carrots is to create a market for royalties from R&D into renewable and sustainable energy. Both the oil and gas and mining industries are already among the top developers of green technology patents, yet monetizing this research is difficult. A company can either use the knowhow and roll out the technology in-house, or be stuck with it.

Meanwhile, a mining company that builds a new mine can sell that mine’s future production to royalty companies in return for a lump sum payment. For the royalty company, it is the equivalent of buying an annuity financed with the production of the mine. By the way, the greening of so-called dirty industries has perhaps the greatest potential to counteract climate change.

In the biotech space, companies have already specialized in financing intellectual property (IP) in return for a share of the revenues generated from the finished product. Why is there no such system in place for green technology development?

Right now, US taxpayers receive a tax break for investments in oil exploration projects. Why don’t we close this tax loophole and use the money raised to pay super royalties to energy and mining companies that develop green technologies? 

Alternatively, we could support dedicated royalty companies in the green technology space to open a new market. Investors could then invest in the shares of these green tech royalty companies and earn a profit from changing the world instead of saving taxes on burning it.

We could even go a step further and learn from successful venture capital (VC) models in countries like Israel. Today, Israel is one of the world’s leading tech hubs and much of the credit goes to the government-funded business incubator Yozma. In 1993, the government established Yozma by seeding it with $100 million in capital. Yozma supported early-stage ventures in exchange for a stake in the projects of up to 40% — provided private investors financed the rest. After seven years, the investors could pay back the government support from Yozma at face value plus interest. It worked, and in 1998, the VC market in Israel grew large enough for Yozma to be privatized. 

This effectiveness of providing a carrot for investments should not be underestimated. Today, Israel spends more on R&D as a share of GDP than any other nation and is second only to the United States in terms of venture capital investments relative to GDP. Israel used carrots to transform its rusty 1990s economy to a modern high-tech one. Why can’t the United States use the same approach to accelerate its transition from a carbon-based economy to a green one and ask Big Oil to lead the way?

If the carrots are tasty and the incentives are right, oil and mining companies will gladly invest in green technologies. The old adage of doing well while doing good is the way forward for all of us. 

And while we may first think of sticks, we should never forget the appeal of carrots.

This was probably the most common question I got for about a decade when I told people that I was working not only in the same job as my wife but literally on the desk opposite to her. We were together 24/7 sharing both our professional and our private lives.

The honest answer to this question is obviously that I am such a nice person and such an admirable and intelligent professional that everybody wants to be around me all the time to benefit from my wisdom. But usually, I gave the politically correct answer that we share many of the same interests and simply get along very well with each other.

Yet, most people I talked to about this subject thought that living and working together is likely to be detrimental for the relationship since it provides additional stress, blurs the line between professional and private life, or simply doesn’t allow either partner to have a life on their own. But looking at the detailed survey answers of German households in a series of initiatives indicate that these fears are not only unfounded but that living and working together may be better for people. The average satisfaction with life, work, and income of people who work with their partner or at least work in the same profession as their partner is somewhat higher than for people who have a partner working in a different field.

Life satisfaction of couples with and without work link

Source: Hennecke and Hetschko (2021)

A deeper analysis of the answers given to life satisfaction surveys reveals that the key driver behind this increased life satisfaction is the better understanding of the challenges the partner faces in his or her job and the better support a partner can give on a daily basis. If your partner works in the same job as you do or even in the same office as my wife and I used to, you tend to have a wingman who understands your frustrations sometimes without needing an explanation. 

This emotional support and understanding as a driving force for higher life satisfaction also mean that people in highly skilled or specialised jobs benefit more from a partner who has a work link. My wife and I used to work in finance, though by now, my wife has decided to do something useful with her career and became a garden designer. But we both have university degrees and worked in jobs that require a fair bit of training and experience. So, we benefitted from our work link quite substantially. 

We have friends who are both professional ballet dancers (by now retired) and married. They both told us that they would hesitate to date someone outside the ballet world because it is impossible to understand for outsiders the physical and mental stress involved in this job. And similar to my wife and I, they appreciated the support and understanding they received from their partner during the practice sessions and performances.

Finally, there is another driver behind the increased life satisfaction of people who have a partner in the same job. In general, the lower income partner (typically the woman) benefits more from this work link. This is driven by two factors. First, the more experienced partner can be a mentor to the less experienced one, and second, the partner with the lower income has a better benchmark for a fair salary. As a result, the gender wage gap in partnerships with a work link is smaller than the wage gap in partnerships without such a link. 

This brings me to today’s top tip: If you are an employer, think about hiring husband and wife teams. They tend to be happier with their jobs and lives, which means they are more productive and miss work less often. And you can reduce the gender pay gap in your company which is something that investors increasingly pay attention to.

What’s the job of a financial planner? While there is probably no consensus of the job of a financial planner in general, one part of the job, I think most people could agree on, is to help investors achieve their retirement goals.

Saving for retirement is one of the most important financial planning exercises we all have to do, and it gains in importance as government and corporate pension funds become increasingly thinly stretched. Even more so, we live in a world where employees of a company no longer have access to defined benefit plans but have to make do with defined contribution plans, which means that the employee bears the investment risk of the pension plan. Making the right decisions with your pension fund investments is crucial as is the effort to make the right decision in how much to save etc.

Unfortunately, I know too many financial advisers who define their job as helping people achieve their retirement goals and then translate this as helping them to pick outperforming funds or stocks. And that is not going well, as a study by researchers from the University of Missouri has shown. They looked at 2,000 pension plans in the United States and the performance of the funds and the plans overall between 2013 and 2015. Crucially, they split the plans between the c80% plans that provided advisory services to the investors and the 20% of plans that provided no such advisory assistance. 

Their results show that when it comes to picking outperforming funds within a retirement plan, the advisors are no better than chance. While the average return of employees in plans with advisers was about the same as the return for employees in plans without advisers, the volatility and downside risks of the portfolios of employees in advisor-supported plans was somewhat higher. Thus, advisers moved investors into funds with higher risk but no compensation for that extra risk.

We could all chime into the usual song and dance how advisers are useless and unable to pick stocks or funds, but that’s not the point. The point is that achieving your retirement goals has nothing to do with picking stocks or funds. The true value add of an adviser lies in the actual planning process, not the selection of investments.

Already a decade ago, Annamaria Lusardi and Olivia Mitchel published what I consider to be one of the most important papers on financial planning of all time. They looked at the type of planning individuals engaged in and how that influenced their net worth at retirement. They distinguished between non-planners, simple planners (people who roughly knew how much of their income to save each month or each year), serious planners (people who have a proper financial plan) and successful planners (people who have a financial plan in place and managed to stick to it throughout their career, aka fairies, unicorns and otherwise unimaginably disciplined investors). The chart below shows that just moving from non-planners to a simple planning exercise increases net wealth at retirement by a factor of two to three. Engaging in serious planning then adds another 25% to 35% in extra wealth at retirement.

This is where the true value of financial planning lies and where advisers really add value: Making investors aware that they need to safe, how much they need to save and how best to manage their income and expenses to achieve their savings goals. Everything else is just noise and not worth your time.

Net wealth at retirement at retirement

Source: Lusardi and Mitchell (2011)

Momentum investors know that in order to exploit the momentum factor it is best to ignore last month’s returns. While stocks that have had positive returns over the last six or twelve months tend to outperform in the coming month or so, stocks that outperformed in the previous month tend to underperform the next. This short-term reversal effect is well known and if you are interested in how big it is, you can download it from Ken French’s database.

Short-term reversal is typically explained with investor overreaction to news that is reversed, once the news has been digested. Stocks thus overreact to positive news and correct afterwards, creating short-term reversals. 

Short-term reversal is why momentum investors typically calculate past price momentum as the performance over the last 12 months minus the performance in the previous month to get better results than by just looking at the return over the previous 12 months.

But what if I told you that there is a group of stocks that does not exhibit short-term reversals? What if I told you that this group of stocks in exhibits short-term momentum, that is stocks that outperformed last month continue to outperform the subsequent month?

In a fascinating paper, Medhat and Schmeling show that while the average stock exhibits short-term reversal, the most highly traded stocks exhibit short-term momentum. Only the stocks with low volume in the previous month show short-term reversal. And the differences are so strong that this short-term momentum effect survives transaction costs implementation lags. And they found it not just in the United States but across 22 developed countries.

Short-term reversal and short-term momentum 

Source: Medhat and Schmeling (2021).

So far, this is just an observation and there is no clear theory why this happens. It seems that short-term momentum exists in high turnover stocks because these tend to be stocks that have many investors with a large variety of opinions trading in the same stocks. And the divergence of opinions creates and underreaction to news and hence short-term momentum as prices digest news more slowly. But that is just a theory. For now, all we have is a fascinating and very large new stock market anomaly that I will be eager to learn more about.

There is a bit of a divide in the community of professional investors about financial news media like the Wall Street Journal, the Financial Times, or The Economist. Arguably, all these publications are extremely valuable to retail investors and people who are working in the financial industry but are not directly involved in investment decision making or security analysis. For these people, these publications are a good way to get information about markets. But for the folks who have an enormous amount of specialised financial data at their fingertips and spend their days analysing that data, there is nothing these publications can write that is truly new.

This is why I don’t read these publications. Not because they are bad (they aren’t) but because I cannot get an edge as an investor from anything that is written in them. The pushback, I get to this opinion is usually that it is worthwhile reading these publications to know what “the street” is thinking and how market sentiment swings. If you believe this, then let me show you some data that hopefully will convince you that you can just as well give up on reading that stuff.

Ioanna Lachana and David Schröder from Birkbeck College in London have looked at thousands of articles in the Wall Street Journal and the financial website Seeking Alpha about US stock markets to measure how they influence the S&P 500. They created a variable that measure how optimistic or pessimistic an article is about the market and tried to find out if there is an impact on S&P 500 returns the next day, or further in the future. Using a variable that measures net pessimism (which I have reversed into a net positivism variable) they found that more positive articles in the WSJ or on Seeking Alpha lead to higher S&P 500 returns the next day. But before you get excited, the impact is a whopping 0.05% to 0.1% difference in returns. And if you go beyond one day, there is absolutely zero impact (the chart below isn’t empty, it’s just that all the bars are zero).

Impact of more positive articles in financial media on the S&P 500

Source: Lachana and Schröder (2021)

Using the New York Times archive, they could even show how the influence of news media on the market declined over time.

Declining impact of news articles on S&P 500 returns the next day

Source: Lachana and Schröder (2021)

Since the 1960s markets, reading the news to get a “feel for the market” has been a waste of time. If you aren’t a professional investor, you get important information out of financial news, but if you are a professional, you are wasting your time reading that stuff. You cannot get an advantage from the FT, the Economist, or the WSJ.

Reducing and mitigating the negative effects of climate change is first and foremost a technological problem. Yes, we all need to change our behaviour but in the end, these behavioural changes themselves are made easier if we have convenient technology to support them. Until a few years ago, the range of battery electric cars was so low and their price so high that no one except the biggest ecomentalists would spend the money to buy one. Today, the cost of electric cars is almost at par with internal combustion engine cars and their range has greatly expanded. As a result, people like me are going electric.

When it comes to electric cars, the revolution was driven by a US entrepreneur and Europe and China had to catch up. But in general, it is astonishing how little of the innovation in green technology is developed in the United States. When it comes to global leadership on greenhouse gas emissions reduction it is not the innovative United States or rising China, but sleepy old Europe that is leading the charge.

In my view, this is not a historical accident but a result of cultural and institutional differences that makes European countries much more likely to fight climate change. 

The first observation I want to make is the institutional difference between how the economies in Europe, China, and the United States are run. The US is the land of the belief in free markets. Regulation is as light as possible and to be avoided at all costs. When it comes to green technology, this is a serious drawback. Green technology is expensive to develop, capital intensive, and takes a very long time to become cost-competitive with traditional technologies. It simply is not possible like in the software space to develop a new product and then roll it out aggressively to capture a large market share in a few years and then become profitable. Unless you have a backer with nearly limitless resources and an iron will to see this project through, a free-market economy will kill off this kind of innovation long before it can become competitive. 

China with its guided capitalism would theoretically be a natural habitat for technological revolutions because the government could finance and protect emerging new technologies for long enough to make them competitive. However, over the last couple of decades, the Chinese government was mostly interested in improving the living standards of the Chinese as rapidly as possible. This meant focusing less on innovation and more on copying technologies from the West and reproducing them at a lower cost. It is what has turned South Korea and Japan into global industrial powerhouses. Now that China is at the crossroads where it has to escape the middle-income trap, the country focuses intensively on becoming a global leader on 21st century technologies like batteries and other green technologies. In my book on geo-economics, I have written in detail how China tries to do this and what that means for the coming decade. So, for the last two decades, China was out of the picture as well.

This leaves us with Europe and its focus on social market economy where regulations play a bigger role to avoid market failures. In Europe, it is common to introduce subsidies for new technologies or to foster market changes. Thus, subsidizing wind and solar energy until it became competitive was nothing new to European policymakers. And if it created jobs, politicians were quick to jump on board. IRENA reports that the total number of jobs in solar wind and biomass in 2019 was 9.5 million, up from 5.6 million in 2012. In the EU 1.25 million jobs depended on these technologies in 2019, almost twice as many as in the United States.

The second key reason for European leadership was cultural. The United States is the land of “move fast and break things”. It is the place where entrepreneurs can develop a new technology or a new product without much red tape, put it out in the market and see what happens. If it kills a few people or makes infringes on their privacy rights, so be it. The worst that can happen is you get sued, but most of the time, that doesn’t happen, or nobody can prove that it was your fault. This is why the United States is the land of Facebook and Google, of low food quality standards and fracking. Meanwhile, most European countries act based on the cautionary principle. First, you have to prove that your product does no harm, then you can roll it out. This “do no harm” principle is so ingrained in Europe that it is for example one of the three key principles for the new EU taxonomy on sustainable economic activities. If you run a business and you want it to be accredited as a sustainable business, you have to show that it does no harm to the environment and the climate. 

This cautionary principle in Europe means that there is a much higher incentive to develop new technologies that solve existing or future problems. I tend to say that America has never met a problem that it couldn’t solve by throwing more money at it or using more energy. And in my view, most of what Silicon Valley does is solve problems for young white men with disposable income. Silicon Valley doesn’t solve hunger, fight malaria (or Covid, for that matter) or inequality because the people who work there aren’t hungry, have health insurance and money. 

In a free-market economy, developing green technology puts you at a first-mover disadvantage. Much better to wait until someone else has made the investment and developed the technology until it is ready for primetime. But if everybody thinks that way, nobody ever tackles that problem. Unless you have a couple of stupid Europeans who care about more than just making money. 

I recently attended a very interesting presentation by Dan Ariely hosted by one of the best consultants on corporate performance, and employee management, MindGym. These guys approach human resources from an angle that is truly based on science, not management theory or the latest fad in how to motivate people and manage organisations.

So, they teamed up with Dan Ariely, one of the best behavioural psychologists in the world, and asked what makes a company perform really well? The answer will surprise you: It’s their people. Everybody always says that we live in a knowledge economy, but hardly anyone seems to really understand what that means. One answer Dan provides is that you need a workforce that is highly motivated and feels that it is being treated fairly and can grow within the organisation. Leaving everything else equal, companies with a more motivated workforce perform better in terms of productivity, profitability, and share price according to Dan.

But, in my view, there is a step missing and that step is, as usual, hidden in the term “everything else equal”. If you work in the same company as Dilbert, which is full of morons, you can be as motivated as you like, neither you nor the company you work for will ever be successful. 

So, step one is: hire skilled people that will succeed at their job.

In his presentation, Dan mentioned that interviewing candidates is one of the worst methods to select candidates for a job. It creates the illusion of knowledge about the candidate and an illusion of being able to predict his or her performance without any evidence that the interviewer actually gets better at predicting the performance of the candidate. In fact, first impressions are usually wrong when it comes to interviewing candidates because the three necessary conditions for first impressions to be informative are not met, as explained by Daniel Kahneman here. First impressions tend to be reliable if you are in a controlled environment, doing an exercise that you have done very often and you get immediate feedback. Job interviews may or may not be a controlled environment, but for most of us it is not something we do every day, and it certainly is not something where we get immediate feedback. In fact, feedback about the performance of the new hire is months down the road from our decision to hire him or her.

Second, there is plenty of evidence that people tend to hire people that are like them and that they can relate to. However, there is absolutely zero evidence that this leads to the selection of high-performing candidates.

If interviews are actually reducing your ability to hire high-performing candidates, what are the important attributes to look for? It’s not politically correct to say this, but the evidence is clear. The candidates with the highest cognitive ability tend to be the ones that perform best. So ideally, you would just ask every candidate to perform an IQ test including verbal reasoning skills, etc. And if you can’t do that, then here is a top tip: Look at the grades the candidates had in school or at university. The literature on human intelligence shows that school grades have no predictive ability to forecast if someone is successful in life, in the labour market, or elsewhere. The only thing that grades in school are highly correlated with is IQ. The reason why school grades are not predictive of success in life is not that schools don’t prepare students for real life, it is because real life does a horrible job at identifying skilled people and then promoting them.

But cognitive ability isn’t everything. Someone may be smarter than everybody else, but if he is a smartass then he won’t succeed. Cognitive ability is a foundation on which to build, it isn’t the finished product. A person will be successful only if he or she is willing to learn and not just in university or for tests but learn every day. And never, ever stop. I do this by writing these missives that force me to look for new things to learn and write about. You do this by reading these missives every day. Congratulations!

Finally, the last of the important predictors of a successful employee is emotional stability. It is incredibly difficult to work with someone who is an emotional volcano, ready to erupt at any time without prior notice. But it is also very difficult to work with someone who is so introverted and insecure that he or she will never dare to say anything or provide valuable insights. What you need are people that are in the happy middle. Emotionally strong, but not overbearing, resilient against stress, and not defeatist when facing challenges.

If you find all three elements (cognitive ability, a willingness to learn, and emotional stability) you have found a great new hire. Congratulations, now do that a couple of hundred times and you can move on to step two and read Dan Ariely’s research on how to motivate people.