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"Therefore I say: One who knows the enemy and knows himself will not be in danger in a hundred battles."
In all forms of competition -- whether sports, business, or ancient Chinese warfare -- having an intimate knowledge of your opponent's weaknesses, as well as your own, is the most important factor in securing victory. In the competition of investing, Mr. Market is every investor's most formidable opponent, so taking advantage of his shortcomings is an absolute necessity in the battle for superior, market-thumping returns.
Of course, Foolish investors don't need to view stocks with the seriousness of combat to succeed. Regardless, it's always good to brush up on Mr. Market's soft spots, so that you can hit (or buy) where it hurts him the most!
Mistakes of the mind
We've written extensively here at the Fool about the fascinating subject of behavioral finance, because psychology plays an absolutely critical role in the financial decision-making process. Heavily influenced by the pioneering ideas of Benjamin Graham and David Dodd, academics within this field have postulated that our brains are wired with decision-making "glitches," or flaws, that cause investors to make habitual, small-f foolish investment mistakes.
Here's a short list of what we believe to be the three decision-making weaknesses to which we Fools, along with Mr. Market, are most susceptible.
1. Overreaction bias
Human beings are pattern-seeking individuals. Generally, this behavior keeps us out of a lot of trouble. However, huge problems arise when we try to find patterns where they don't even exist and then overreact to a few choice circumstances.
For instance, look at Freeport-McMoRan Copper & Gold (NYSE: FCX ) . This mining company took it on the chin in late 2008 as the commodities bubble burst. The stock lost more than 80% during its decline.
Now, though, gold and other commodities have had huge recoveries from their late-2008 levels, and prospects for the mining industry look a lot more favorable than they did earlier this year. That optimism has fueled a big rebound, with shares of Freeport having more than quadrupled from their lows.
The concept of representativeness refers to the use of stereotypes in making decisions, and naturally, it's a shortcut that doesn't make a whole lot of sense. For example, most of us would agree that judging a person's character based simply on their gender or nationality is fundamentally flawed. Likewise, haphazardly dumping shares of a single company based simply on the industry to which it belongs is also fraught with error.
In 2004, New York attorney general Eliot Spitzer shook up an entire industry by charging some of the biggest names in insurance with collusion and fraudulent bid rigging. Heavyweights such as Marsh & McLennan (NYSE: MMC ) and AIG (NYSE: AIG ) all saw their market caps significantly slashed when they were implicated in Spitzer's lawsuit.
But in the midst of all this controversy, insurance brokers that were merely being probed for further information had their shares come under tremendous pressure as well. Even Warren Buffett's Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) sold at what was then a 52-week low, over fears that Spitzer would also implicate its reinsurance subsidiary, General Re.
Of course, the panic and bargain opportunity was short-lived. Mr. Market soon realized that the misunderstood conglomerate -- constructed by Buffett as a financial fortress -- didn't deserve to have its shares pushed downward simply because it was operating in the insurance industry. Mr. Market apologized for his mistake, and while Marsh & McLennan and AIG have struggled since then, Berkshire shares nearly doubled from those levels before falling back during the financial crisis.
3. Herding behavior
Anytime your humble Foolish author did something stupid growing up as a result of unrelenting peer pressure, my dad would inevitably look at me and ask, "Well, if your friends jumped off a bridge, would you jump, too?" Most of us are taught at a very young age that a specific act isn't necessarily good or bad just because others are doing it.
Yet as adults, many investors base their buy and sell decisions primarily on whether everyone else is doing it! This herding behavior is best characterized by certain "momentum" strategies that call for market purchases when stock prices are going up, and sales when they are going down. In other words, it's no more than an extremely dangerous and complicated game of copycat. I mean, if the market jumped off a bridge, would you jump, too? Momentum strategies say, yes -- jump! But Foolish investors know much better.
The great thing about herding behavior is that it creates tremendous entry points for opportunistic Fools who seek to take advantage of the phenomenon, rather than participate in it. For example, during the infamous tech sell-off (OK, crash) of 2000 through 2002, investors were not only dumping shares of unproven Internet startups; they were also indiscriminately selling shares of well-established firms such as Intel (Nasdaq: INTC ) and Hewlett-Packard (NYSE: HPQ ) , which had the experience to weather the storm. So why on earth would investors make such a mad dash for the exits and unload these quality companies? You guessed it -- because everyone else was. (Boy, would their parents be upset!)
Move in for the haymaker
It might not be enough to analyze a company and basically state that the stock is undervalued. Fools also need to be able to understand why the shares look enticing.
If there are irreparable, fundamental problems with the company, its stock could very well be a value trap, rather than an authentic bargain. However, if the firm you are investigating is selling at a bargain-basement price simply because investors are overreacting, discriminating against the company because of industry events, or moving mindlessly with the herd, get ready to buy with a one-two flurry. At these points, Mr. Market leaves himself wide open -- and most vulnerable to getting thumped.