How much are your emotions costing you each year? Are markets really efficient all the time? Is following the consensus view the best strategy to take? And what factors will move stock prices going forward?
During a recent visit to Fool HQ, Michael Mauboussin, Chief Investment Strategist at Legg Mason
1. Lack of contrarian thought
"Markets are inefficient, and sometimes it takes a crisis and a market meltdown akin to the magnitude of the current one to remember that," Mauboussin said.
According to Mauboussin, there are three ways to obtain market efficiency:
- Mean variance efficiency (all financial concepts are mean based)
- Absence of arbitrage (arbitrage fails in extreme situations)
- Wisdom of crowds
Mauboussin favors the "Wisdom of Crowds" theory, first published by James Surowiecki to explain how market behavior influences prices, as the best approach to understanding the markets.
People are often influenced by the mainstream view -- which is correct most but not all of the time. For example, the mainstream didn't question the wisdom of the subprime mortgage market and its boost to the bottom lines of homebuilders like Lennar
The "Wisdom of Crowds" theory, however, only works when there are incentives, information is brought together into a market, and diversity of thought processes (people who approach investing differently) are all present. If one of the components fails, markets will become inefficient, says Mauboussin.
Many times it's the diversity of thought that can be lost in crowds. People can be intellectually smart, but can make bad decisions based on emotions or the environmental influences around them. When diversity breaks down, Mauboussin says it can have an illogical impact on stock prices. "You can reduce diversity [of thought] while observing no change in asset prices, "but then 'woosh' there's a big change."
2. Emotions impair objective investment judgment
Mauboussin said that being a value investor can be difficult not because of the facts so much as our own temperament. "We are often our own worst enemies -- because we have a hard time dealing with the markets on an emotional level," he said.
Mauboussin says emotions get in the way of judgment in the stock market. "There are 'psychic' costs when measuring portfolios," he says. He points to behavioral economists Benartzi and Thaler's claim that an investor with a 20-year time horizon has a "psychic cost," or costs to one's portfolio due to decisions based on emotions instead of facts, of 5.1% per year.
Mauboussin pointed out that people feel the emotional blow from losses twice as much as they enjoy gains. "People will willingly give up positive net present value investments if they've recently suffered losses," he said.
3. The biggest mistake value investors make
Emotions can certainly cloud judgment, but Mauboussin argues that the largest error made in investing is the failure to distinguish between fundamentals and expectations.
"When fundamentals are good, people want to buy, when they're bad they want to sell," he said. "The key is the difference between price and value." A vivid example is the nine-year performance of tech titans Cisco Systems
Therein lies the place for contrarian thought. Mauboussin, paraphrasing value investor Seth Klarman, said that value investing requires a contrarian streak and a "calculator." In other words, investors have to look at the consensus view and assess what the "crowd" has built into the stock price.
4. Mauboussin on the future of markets
Mauboussin says he thinks about the future investment landscape through two fundamental drivers to stock prices: (1) earnings, cash flow, and dividends, and (2) risk.
"If you look at earnings right now, by most peoples' view we are below the trend line in earnings power," he said. "Earnings power will be higher and come back toward that trend line at some point."
Mauboussin likes to look at the National Income Product Accounts (NIPA), put out by the Bureau of Economic Analysis, as a guide to the outlook for corporate earnings. The data contains profits that companies report to the government for tax purposes, or as Mauboussin calls it, "the truth." During 2006 and 2007, NIPA showed earnings were less rosy than S&P 500 earnings, and now Mauboussin says the inverse is true.
For the second component, risk, Mauboussin uses the VIX (the standard volatility index) as a proxy. He says, while risk levels have come down, they still remain 50% above historical trends.
To complete the story, Mauboussin says, future earnings power is priced lower than it should be, while risk still remains high by historical standards. "Moving away from that was obviously very bad for markets, which is why we've had this difficult time. We're moving more toward a constructive environment."
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