Studying investor behavior is a two-part process. The first, limiting the influence of biases and misbehavior improves your returns. The second step is to seize opportunities created by those who refuse to learn the same lessons you did.
The opportunities created by the short-term nature of the herd are why most strategies work. The heart of value investing revolves around this idea. Value exists because investors mistakenly discount current prices for an indefinitely bleak future.
But first, that means not getting swept up in the herd behavior you’re attempting to profit from. Optimism and pessimism, greed and fear, risk tolerance and risk-aversion are easier to latch onto when others do the same. Safety in numbers feels comforting until you find out, a little too late, that the numbers were acting irrationally.
Seth Klarman likes to point to the importance of discipline and patience in investing. Conveniently, discipline and patience are literally a contrarian stance as far as herd behavior is concerned. The independence it creates — to have a process you stick to no matter what — becomes the backbone to successful investing.
Of course, it sounds easier than it is, which is probably why Klarman reiterates the opportunities so often created by herd misbehavior. I pulled a few examples below from his book Margin of Safety and letters. It sits as a reminder of what’s at stake — possible losses on one hand and missed opportunities on the other.
A second important reason to examine the behavior of other investors and speculators is that their actions often inadvertently result in the creation of opportunities for value investors. Institutional investors, for example, frequently act as lumbering behemoths, trampling some securities to large discounts from underlying value even as they ignore or constrain themselves from buying others. Those they decide to purchase they buy with gusto; many of these favorites become significantly overvalued, creating selling (and perhaps short-selling) opportunities. Herds of individual investors acting in tandem can similarly bid up the prices of some securities to crazy levels, even as others are ignored or unceremoniously dumped. Abetted by Wall Street brokers and investment bankers, many individual as well as institutional investors either ignore or deliberately disregard underlying business value, instead regarding stocks solely as pieces of paper to be traded back and forth.
Value investing by its very nature is contrarian. Out-of-favor securities may be undervalued; popular securities almost never are. What the herd is buying is, by definition, in favor. Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked.
If value is not likely to exist in what the herd is buying, where may it exist? In what they are selling, unaware of, or ignoring. When the herd is selling a security, the market price may fall well beyond reason. Ignored, obscure, or newly created securities may similarly be or become undervalued.
Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. By contrast, members of the herd are nearly always right for a period. Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value.
Holding a contrary opinion is not always useful to investors, however. When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use. When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/ reward ratio, allowing contrarians to bet against the crowd with the odds skewed in their favor. When investors in 1983 either ignored or panned the stock of Nabisco, causing it to trade at a discount to other food companies, the risk/reward ratio became more favorable, creating a buying opportunity for contrarians.
…the herd mentality of investors can cause all companies in an out-of-favor industry, however disparate, to be tarred with the same brush.
It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it. Yet distancing yourself from the crowd is an essential component of long-term investment success.
Given the competitiveness of the investment business, we believe it is important in every investment to have an edge, an advantage over the herd. This edge could be a willingness to take a long-term perspective in a short-term-oriented market, a tolerance of complexity when others crave simplicity, or the absence of constraints which either impede the ability of others to act or force them to act in uneconomic ways.
Investors must remember — although at the peak of emotion they sometimes forget — that securities are fractional interests in, or claims on, businesses that have their own assets and cash flows. They have (usually) ongoing business value and (at least hypothetically) a liquidation value. The herd can irrationally lose sight of the underlying assets or long-term prospects of a business when it focuses on price movements triggered by disappointing quarterly results or the latest overheated social networking IPO. Often, a company’s share price fluctuates significantly even in the absence of fundamental developments, such as when a sizeable seller needs cash quickly.
We never shoot for high near-term investment returns. Trying too hard to earn positive results, or assessing performance too frequently, can drive anyone into short-term thinking, herd-like behavior, and incurring higher risk. We do our utmost not to allow this to happen.
One reason the markets are now, and never will be, efficient is that the search for alpha is not like an Easter egg hunt, where the number of eggs is finite, and the hunt is over when the last hidden egg is found. In financial markets, alpha is continuously being seized by the most adroit searchers, but new alpha is regularly being created as a by-product of investors’ herd-like emotional overreactions, cognitive biases, institutional constraints, or unwitting mistakes. The resultant mispricings inadvertently leave behind alpha for others to uncover.
Margin of Safety