"Therefore I say: One who knows the enemy and knows himself will not be in danger in a hundred battles." -- Sun-Tzu
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 as seriously as hand-to-hand combat to succeed, but it's always good to brush up on Mr. Market's soft spots so we can hit (or buy) where it hurts him the most!
Mistakes of the mind
We've written extensively about the fascinating subject of behavioral finance here at the Fool 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.
I've made a short list of what I believe to be the three decision-making weaknesses that we Fools, along with Mr. Market, are most susceptible to.
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.
In the second half of 2005, shares of Pfizer
However, as was noted by our Motley Fool Inside Value team, only a single study out of many had linked Celebrex to any high degree of cardiovascular risk, while the company continued to have promising new drugs in the pipeline. Investors were pricing in an absolute worst-case scenario for Pfizer, so even the slightest bit of good news would have sent the shares upward. Though BEXTRA has indeed been taken off the market, Celebrex continues to thrive while Pfizer's operating performance, as a whole, steadily improves.
Shares of Pfizer are currently up more than 30% from their 2005 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 sex or nationality is a line of reasoning that is fundamentally flawed. Likewise, haphazardly dumping shares of a single company based simply on the industry it belongs to 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 bid rigging -- a.k.a. fraud. Heavyweights such as Marsh & McLennan
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
Of course, the panic and bargain opportunity was short-lived. Mr. Market soon realized that the misunderstood conglomerate -- constructed by Buffett as a financial Alamo -- was unfairly being discriminated against, simply because it was operating in the insurance industry. Mr. Market apologized for his mistake and revalued Berkshire shares up 20% to where they stand today.
3. Herding behavior
Anytime I 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?" Surely, anyone reading can relate to, and understand, the timeless wisdom behind this simple rhetorical question. 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 better -- a lot better.
The great thing about herding behavior is that it brings about 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 early 2000, investors were not only dumping shares of unproven Internet startups; they were also indiscriminately selling shares of highly profitable, well-established firms like tax preparer H&R Block
So why on earth would investors make such a mad dash for the exits and unload these quality companies? You guessed it -- everyone else was. (Boy, would their parents be upset!)
Move in for the haymaker
So, my fellow Fools, 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, then 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. These are times when Mr. Market leaves himself wide open and most vulnerable to getting thumped.
Moody's is a Stock Advisor pick. Pfizer and Berkshire Hathaway are Inside Value recommendations. The Inside Value team has been knocking out the market for quite some time. Give the newsletter a try free for 30 days to get in on the action.