Patterned Irrationality
The Efficient Market Hypothesis says that equity
markets are efficient and that the current price of a stock
represents accurately everything that is known about the company. On
the other hand, Jeremy Grantham says, "I believe that markets are
usually inefficiently priced, both in detail and in aggregate, and
that they are driven by very fallible, emotional investors who have
neither the mathematical nor the psychological means to process data
efficiently in economic terms, nor, in the case of professionals,
the incentive."
I have come lately to the view that markets may
be efficient at evaluating data but are almost always a little
psychotic. In this regard Ben Graham's metaphor about Mr. Market is
helpful. Mr. Market knows all the numbers and is perfectly capable
of using the numbers to arrive at a logical figure for the intrinsic
value of a stock. The problem is that he is bi-polar and his figure
for IV is affected not only by the numbers, but also by his mood.
His mood changes rapidly sometimes on a daily basis, so his estimate
of a company's intrinsic value changes with the background noise,
and that $1.00 in earnings may be worth $20.00 on day one and $15
.00 on day two.
Charlie Munger gave a lecture in 1995 at Harvard
University on behavioral economics ("How could economics not be
behavioral? If it isn't behavioral, what the hell is it?").
The title of the lecture was "The Psychology of Human Misjudgment." Of the 24 factors he discussed, most operate on the subconscious level and have very little exposure to rational thought. Almost all of the factors are involved in the decisions we make when investing money.
Huge and Predicable Patterns
The fact is that financial markets are not just
about efficient collection of data, but they are also about mob
psychology and human emotions. That was obvious to Charlie forty
years ago, but has only recently been recognized by the graduate
schools of our leading universities
"... just out of our respective graduate
schools, my friend Warren Buffett and I entered the business world
to find huge predictable patterns of extreme irrationality. These
irrationalities were obviously important to what we wanted to do,
but our professors had never mentioned them. This was not an obvious
or easy path¦ I came to the psychology of human misjudgment almost
against my will; I rejected it until I realized that my attitude was
costing me a lot of money," From "Of Permanent Value" by Andrew
Kilpatrick
This is of course not completely true. Ben
Graham at Columbia was teaching about 'Mr. Market', and Buffett says
that this was one of the most important things that he learned from
Graham. This is certainly Graham's attempt to explain Charlie's
"patterned irrationality."
In the past Buffett has been able to focus of
the "huge, extreme" patterns of irrational behavior: closing
partnerships in 1969, the teenaged boy in harem market in the late
seventies, and of course the granddaddy of all irrationality, the
tech bubble. On a smaller scale it would seem that there was a good
deal of irrationality in the price of Coke in 1988 and Wells Fargo
in 1991. Warren and Charlie were practicing behavioral economics 30
years before anyone else had uttered the term.
With all these opportunities for misjudgment,
the market may indeed be very efficient at incorporating all that is
known about equity, but at the same time there is certainly no
reason to believe it is any less efficient at incorporating
irrational behavior. Investing money is for most people a very
emotional process, and it is easy to pay too much attention to the
market. Sell fear and buy greed is a natural human response that
causes you sell low—buy high.
Almost all of the irrational behavior we see in
the stock market has its roots in Charlie's 24 rules about human
misjudgment. I think the best profit opportunities already have a
strong psychological element, and that as the principles of value
investing become more widely respected and understood, most descent
mispricings will arise from irrational behavior. It seems that every
time I see an interview with a money manager today, the manager says
he wants to buy $1.00 for $.50. Value investing has gotten a lot
more popular in the last three or four years, and that might be one
reason it is so difficult to find undervalued equities in today's
market.
In the stock market, the last thing you want to
see is a lot of money doing the same thing you are doing. The more
you hear people pushing value investing, the more difficult it will
become to make money as a value investor. For me, this means it is
time to look for patterned irrationality. So it would seem a good
time to review Charlie's 24 rules.
"Incentive-Caused Bias"
Number Three on Charlie's list is an
"Incentive-Caused Bias." This is a huge factor in creating irrational
patterns in financial markets, and it exists whenever compensation
systems create conflicts of interest. An obvious example is a
financial advisor paid by commissions. The pay structure creates an
incentive to sell, so the broker or insurance salesman has to
develop a bias that allows him to ignore this conflict. This bias
affects everyone who works under this pay structure because if the
sales person has not developed the bias, they will not be around
very long.
For a broker it means he has to present
something that the customer will buy and usually the customer wants
to buy whatever is hot. So the commission system tends to reinforce
the current market psychosis. Decisions made for emotional reasons,
and not based on rational judgment. As Charlie says, misjudgments
work on the subconscious level, so while the investor thinks he is
making a rational decision, what he doing is whatever makes him
comfortable emotionally.
Mutual fund managers get paid (and keep their
jobs) based on the assets they have under management. But money has
feet and comes and goes based on short-term performance or whatever
sort of irrational behavior currently infects the people buying the
funds. The bias of the fund manager becomes one for doing whatever
is necessary to attract funds. This turns the fund manager into an
asset gatherer rather than a money manager.
In all of these cases, the bias becomes a
vehicle for transferring irrational behavior from the customer to
the market itself. To the extent the bias is in operation, the
market is not reflecting the rational judgment of professional
managers, but emotions of the individual investor, and the
irrational behavior gets transferred upward from the investor to
drive the market in very strange directions.
So the money gatherers dance to the tunes played
by their customers and the irrationality of the less sophisticated
seeps into and eventually (as in 1999 and 2000) overwhelms the
financial markets.
It seems pretty clear to me that if you want to
make money from the financial markets you must learn to recognize
these patterns of irrational behavior. Human nature being what it
is, financial markets are not likely to get more rational in the
future. Many of the largest and most tradable inefficiencies in the
pricing of stocks are likely to be found in the area of human
misjudgment.