In Michael Mauboussin’s great research paper titled – Who Is On The Other Side, he provides five key insights into how investors can effectively take advantage of behavioral inefficiencies, which he listed as:
- Be Mindful Of Sentiment And Overextrapolation
- Rely On Valuation
- Lean On Facts
- Or, Listen To Benjamin Graham
Here’s an excerpt from that paper:
How Beliefs Spread. The final lesson is how investor beliefs come to be correlated. There is a large body of research on this topic, but at the core you need to understand a model of how ideas or information propagate across a network.
Epidemiologists use a model to describe the spread of disease that is analogous to the spread of beliefs, including fads and fashions. The model considers the degree of contagiousness, the degree of interaction, and the degree of recovery. The model’s output is intuitive. The higher the contagiousness and interaction, the higher the likelihood that a disease or belief will spread.
Investors attempting to assess belief propagation in markets need to bear in mind a few points. First, it is inherently difficult to anticipate which ideas or products will be popular. For example, film and music studios struggle to create hits. Second, humans are inherently social and most have a desire to conform to the crowd’s beliefs.
Scientists even have a sense of the neurobiological basis for conformity. Informational cascades occur when individuals follow the decisions of those who precede them without regard to their personal information. For a fad or fashion, conforming means you won’t stand out in a way that makes you uncomfortable.
In markets, diversity breakdowns often include both new investors participating and seasoned investors sitting it out. These new investors are commonly individuals. When individuals buy an investment or investment theme, the probability of a diversity breakdown rises. The dot-com boom and Bitcoin are two good illustrations. Likewise, when seasoned investors stop betting against the investment or investment theme, they contribute to the lack of diversity. With no countervailing opinion voting in the market, decision rules converge and diversity suffers.
But asset markets have an additional element: If you join the crowd early enough in the belief that an asset price is going up and buy accordingly, your wealth initially increases. This reinforces the notion that you made a good decision. The asset price influences you and makes you richer, which feels good. Until it doesn’t.
Finally, investors feel the pressure to conform. The CFA Institute surveyed more than 700 investors and found that “being influenced by peers to follow trends” was the behavioral bias that affected decision making the most. It is difficult to beat your peers if you are doing the exact same thing that they are doing.
How does an investor effectively take advantage of behavioral inefficiencies?
Be mindful of sentiment and overextrapolation. Using Graham’s metaphor, Mr. Market is generally reasonable and price is roughly equivalent to value. But Mr. Market is prone to extremes. When sentiment is uniformly positive or negative, be prepared to visit the opposite side of the argument. But being a contrarian for the sake of being a contrarian is a bad idea, and the consensus can be correct.
Rely on valuation. When markets go to extremes, valuations tend to follow. The crucial question is, “What expectations for future financial results are implied by the current price?” When sentiment shifts are excessive, expectations become unduly high or low. Do the math. Figure out what you have to believe to justify the prevailing price, and compare that to plausible scenarios.
Lean on facts. When an asset price is under the spell of extreme sentiment, make an effort to explicitly separate facts from opinions. A fact is information that is presumed to have objective reality and therefore can be disproved. An opinion is a belief that is more than an impression but does not meet the standard of positive knowledge. As a result, an opinion may be difficult to disprove. Both facts and opinions are useful for investors, but facts should rule the day.
Timing. Behavioral inefficiencies can have different time cycles. For example, momentum tends to reverse over a relatively short period of time of less than a year. Large bubbles can take years to burst. A number of prominent value investors, including Julian Robertson at Tiger Management, closed their funds following the dot-com boom in the late 1990s. The main point is that taking advantage of behavioral inefficiencies can take more time than investment managers perceive they can afford.
Benjamin Graham offered what might be the best advice. He said, “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ. (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.)”
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