I was reading Investors Chronicle from 26th April to 2nd May with ‘Breaking the Mould’ on the cover and on page 32 I came across a very interesting article by Alex Newman entitled ‘Finding the Edge’ and it got me thinking and it also struck me that there were some useful concepts in here for me to look further into and to share with a Blog that Reader’s might appreciate.
If you have access to a copy of the mag or the online version, it is certainly well worth a read although I must say that it is rather too academic and theory based for my tastes – I found myself re-reading several bits a few times before I really figured out what point was being made. It suffers I think from the usual issues of being far too over-complicated and I suspect the Academic Research was done by someone who is more of a Professor and Economist than an actual person who Invests or Trades in Shares (or any Asset for that matter). I see this sort of thing all the time - I find it useful because I can take snippets of what the Academic Research covers and think about it in the context of what I do with Stocks and my experience and understanding of how Markets work in reality - and of course in The Real World things tend to be highly different.
The essence of the Article is a Paper produced by Michael Mauboussin (I’m sure he does a French soft cheese !!) who is the Head of Research at BlueMountain Capital Management and it is titled ’Who is on the other side?’ and the thrust of the Paper is to investigate and discuss various sorts of Information and Asset Price inefficiencies and the thrust of the argument seems to be that there are considerable inefficiencies caused by different abilities of Market Players to access Information (this is to a large extent about the cost of getting such Information via Research Notes etc.) and then these are related to Asset Price inefficiencies (that’s a lot of ‘thrusting’ by the way, as the proverbial Actress and Vicar may know all about).
OK, after that last paragraph you are probably totally in agreement with me that this is all a bit over-complicated and academic. To try and put it in more simple terms, he argues that differences between a Price of an Asset and its Value can be caused partly by Information inefficiencies. To some extent this does make sense, but of course the ‘inefficiencies’ in how an Asset is priced are also from lots of other factors which I would suggest are probably psychological and behavioural as much as anything.
Another way to look at it is that inefficiencies in Asset Pricing are opportunities for Investors/Traders to exploit and it is efficiency in Asset Pricing which we actually want so that the Price then moves more towards its True Value after we have bought into the Asset (obviously the same thing applies if going Short but here we think an Asset is over-priced due to inefficiency and we want it to move down to its True Value as we see it).
Anyway, irrespective of whether or not I agree with the whole reasoning etc. behind the article, there are some very good bits in here that I can relate to and I will pull them out and put some of my thinking where appropriate.
This chunk of text from the article is spot on and something I am sure most Share Investors will recognise. Of course Ben Graham is a true Legend of Investing and his classic book, ‘The Intelligent Investor’ is a must-read although it is quite heavy going in parts (nip over to Wheelie’s Bookshop and you will find a copy of it there) and I am sure most of us will know the idea of ‘Mr Market’ and we have certainly experienced how he can swing from being suicidal (like he was at the end of 2018) to almost total euphoria like he has been in recent weeks. It is like he has prescriptions for various mind-bending drugs which cause extreme chemical imbalances in his brain !!
‘Behavioural inefficiency covers the way collective investor sentiment causes price and value to diverge. Although behavioural finance is a relatively young field of study, it has echoes of the writings of Benjamin Graham, who expressed the concept through the character of ‘Mr Market’; a metaphorical actor who generally offers investors sensible prices, but who is prone to bouts of wild swings in optimism and pessimism.’
It is these “wild swings of optimism and pessimism” that provide a great source of Market inefficiency for us to exploit as the change in moods causes the Price of Assets to diverge often to a large extent from their true Value (this is the Price inefficiency that Mr Mauboussin goes on about – that’s when he’s not making the cheese).
This next chunk of text goes into the subject of Overconfidence and this is something I have been thinking a lot about lately because it is very much something I try to look for in myself and it is something I see all the time in others I think. It is without doubt a hazard of the way someone like myself Invests where it is to a huge extent ‘Ego trading’ where I am really having to hold a very high level of belief that I see Value in a Stock where others don’t - and of course this just smacks of overconfidence and this is evidenced by the fact that I get a lot of Trades wrong. By definition, a Contrarian Investor, which I often tend to be, is essentially putting Cash on the line on the belief that they know better than the wider Market does - the drawbacks in such an approach are obvious. However, if you take the opposite view and believe that “the Market is always right” (aha, the ‘Efficient Market Hypothesis’) then how can you make money? My view is that “the Market is always wrong” – it is just the level of degree of how wrong it is that matters and varies almost constantly.
‘But escaping investor behaviour that tends towards inefficiency is no easy task. Mr Mauboussin says that the process of belief formation itself - that is, coming to an investment decision - is highly susceptible to three forms of overconfidence: overestimation, overplacement and overprecision. Put simply, these are an individual’s inflated sense of absolute ability, relative ability and accuracy. Even portfolio managers are guilty of wildly overestimating their confidence levels.’
In terms of the 3 forms of overconfidence that Mr Soft Cheese cites here, overestimation can arise from aspects such as believing Consensus Forecasts for Earnings and consequently overestimating a likely Target Price or simply overestimating the growth potential of a Market for the Goods or Services a business sells. Such overestimation probably has loads and loads of possible errors when thinking about how a Business is likely to develop in the future - it is not just in things such as the Financial Numbers that are likely but also in aspects such as wider Interest Rates in an Economy or changes in Technology or something. Those are aspects of overestimation related to Stocks we invest in but actually Mr M is really talking about our own inflated sense of our Investing Ability - I suspect this applies to most of us !!
We can also overestimate longevity of Directors staying at the Company. I am pretty sure that the default position of most Investors is to say “oh, the CEO at XYZ company is superb” and implicit in such a statement is that the CEO is expected to stay at the business. However, it can often catch us out when the Company suddenly announces his/her departure and that has the potential to drastically alter the future prospects of the business.
Overplacement with relation to our ‘relative ability’ is how good we are as Investors or Traders when compared to others. I guess it is a bit like Car Drivers - everybody if asked thinks they are an ‘above average’ Driver but in reality of course this is impossible. No doubt we all think we are above average Investors and probably think we are in the top 15% or something - but in reality we are probably much worse than this !!!
Overprecision I can relate to actual Stocks we invest in but I can’t see it in the same context as the overestimation and overplacement which I just talked about which are to do with how we rate in our Investment Skills. In terms of accuracy regarding Stocks, I guess it is about being too precise with regards to things like Earnings Forecasts and P/E Ratios and suchlike - I think there is a lot of sense in this and I do like to consider all Numbers in a bit of a range or spectrum - and that most definitely applies to Price Targets where precision is an illusion and fantasy. Taking this further, I would say that Markets in general are a very ‘fuzzy’ thing and we should not be too precise and exact about anything. People who’s brains are wired to like exact and accurate things will probably find Markets very difficult to cope with - they are not absolute and precise things - they are fluffy and nebulous and vague in so many ways.
This sort of concept is partly behind my preference to hold a lot of Stocks in a wide Portfolio - although I suspect the overall collective Portfolio will do well (based on what I have experienced before), I cannot have any certainty or precision about which Stocks will perform and which won’t. I can take a stab at which of my Stocks will be big Winners and which will be Losers etc. but in reality it is a pointless exercise because it will invariably be the Stocks you least expect to do well that will outperform all the others. And the Stock you think is brilliant will turn out to be the worst one !!!
This next chunk of text is a bit complicated and hard to understand really. Anyway, I can certainly relate to the idea that when Markets are soaring ever higher and lots of people seem to be trading like possessed demons, there is probably a lot of overconfidence about. Oooops, at the time of writing this First Draft in early May 2019 I suspect the Markets in general are in exactly this frame of mind and we are probably ‘cruising’ for a bruisin’……..’
For ourselves, if we are trading a lot more than normal and getting all excited, then maybe we are suffering from overconfidence and are about to get a kick in the butt !!
“Still, knowing we’re often overconfident isn’t much of a guide to knowing when we are being overconfident. One way to think of this, says Mr Mauboussin is to check for the concomitant symptoms of rising asset prices and heightened trading activity, both of which are closely associated with misplaced confidence.”
In fact, the subject of Over-Confidence is something that I think about a lot and I suspect it is prevalent in many Investors and Traders and can lead to a lot of problems. This next quote from the text about stories regarding Businesses is probably no surprise to anyone:
“Apparently - who knew! - journalists are also equally guilty of this tendency. A 2007 study of cover stories featuring businesses in the ‘Financial Analyst Journal’ found that ‘positive stories generally indicated the end of superior performance and negative news generally indicates the end of poor performance‘.”
Of course it is not just a psychological or Over-Confidence thing – it just seems to be that the Financial Press is often late to a Story especially on Smallcap Stocks which get very little coverage. To an extent I guess Financial Writers are geared to the ‘Fund Management’ world and inhabit ‘The City’ where nobody is interested in Stocks under a particular value as they are just too small for big Funds to be able to buy in any meaningful size. For example, most of the Funds which claim to invest in ‘Smaller Companies’ are actually FTSE350 Funds and that also helps explain why the Smaller Indexes like the FTSE Smallcap and AIM All-Share move very much with the FTSE250. There is of course a psychological aspect and I suspect much of this is Availability Bias and Recency Bias whereby the Writers tend to notice Stories that come to their attention and their Radar probably has a fairly limited range in terms of how effectively it can pick up on Stock Stories before the big moves have happened.
Availability Bias is simply that we are predisposed to Stories that fall onto our laps with very little effort to find them and Recency Bias is about us taking more notice of Stocks that are in our minds in the here and now and we easily forget about some superb Stocks that were taking our attention some weeks ago. This is exactly why I have my ‘Little Black Book’ and when I am looking for a Stock to buy I go back through this List for months and months to see what Stocks are hidden away. It is also why I find less need to read Investors Chronicle immediately when it comes out – what I tend to do these days is to read through certain columns like Chris Dillow and ‘The Trader’ and the earlier pages which are more ‘light reading’ and take little brain power from me when the Mag first hits my mat. Then a few Weeks later I will go through the whole Mag again (mostly ignoring the stuff I have already read which I tick in the corner of the page to denote that I have read it) and this time I focus on Stocks and read with a lot of close attention. This bit feels a lot more like ‘work’ than the easy reading I tend to do over the initial Weekend of publication (I try to avoid too much ‘work’ at the Weekends !!).
OK, that’s it for Part 1, the next Part has more of the same really and should be out next week.
This one contained a fair bit of psychology stuff so here is an old Blog Series from the Archives about exactly that subject (this is Part 3 but there are links to the 2 earlier Parts at the top of it):
These next 2 are very much about the Investor vs Trader thing – I think this is one of the most important distinctions that all Market Participants need to address and you need to be very clear on what you actually are (many problems arise because Investors behave like Traders and vice-versa):
These Blogs are about Psychology and the important concept of ‘TopChopping’ – it is 3 bits and there are links to the earlier parts at the bottom of this one:
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