Pessimism's Potent Profits

In theory, the market is pretty efficient. According to prevailing Wall Street wisdom, rational investors will quickly take advantage of any mispricing, thereby bidding firms back to their true value. That's all fine on paper, but it relies on several assumptions that are just plain false. By learning how and where the academic theory gets lost in reality, you can take advantage of the system for your own personal financial benefit.

The irrational advantage
Probably the biggest hole in the theory is that it assumes that investors are always rational. For that to hold true, investing decisions would largely need to be made in a vacuum. In reality, most people invest for a purpose, not just for academic curiosity. We all want better lives for ourselves and our families. Maybe we're saving for our kids' college. Maybe it's a comfortable retirement we're after. Whatever the reason, investing is a means to an end, and not usually an end unto itself.

If your portfolio gets shellacked, it's not just an abstract paper loss. It's real money that may very well translate to an unpleasant change in your long-term plans. No matter what the academic theories claim, invested money has real-world consequences that change people's behavior away from the purely rational.

Fear and greed
Because of this, emotions play a huge role in people's actual investment decisions. By far, fear and greed loom the largest. When a stock is going down, people's natural tendency is to get scared. After all, it's their money on the line, and they have plans that will fall apart if the cash isn't there when it's needed. As such, folks tend to want to sell a falling security to preserve whatever remains of their capital.

What this means is that selloffs are often far more dramatic than they should have been. As a result, you can snap up shares for far less than they're truly worth. After all, it's called a panic sale for a reason. Just like a department store trying to rid itself of "scratch and dent" merchandise, fear sometimes causes the stock market to offer incredible bargains on companies that are only slightly damaged. As a value-focused investor, you can take advantage of this mispricing to profit.

On the flip side, when stocks are performing exceptionally well, investors tend to want to pile in on the action. Just as fear sends people running from a stock heading down, greed compels them to buy one that's rising. The resulting buying frenzy frequently drives a company's stock dramatically higher than it's truly worth. Unfortunately, just when everyone wants to purchase, the stock becomes its most dangerous. At a high enough price, there's nothing but hope supporting the stock. As a value investor, that's your opportunity to sell or your cue to stay away.

The consequences
The upshot of all this emotionally driven buying and selling is that stocks tend to trade both well above and well below their true worth from time to time. You can see this by looking at something that I like to call the emotion factor. In essence, it's a comparison between the 52-week low and high prices of a company and its expected five-year growth rate. The higher the price changes compared with the growth rate, the more likely that emotion is involved.

The logic behind the emotion factor is this: If the market always efficiently reflected the future, then stocks would always be priced at their true value. Consequently, any growth in the stock should be fueled only by growth in the underlying business. The larger a stock's movement variation with respect to its expected growth rate, the less likely that its price will always precisely track its true worth. Here's what it looks like in practice.

In the middle of the list is former Motley Fool Inside Value selection Intuit. Market worries about the overuse of stock options, competition heating up against a series of much larger players, and slowing growth had held its shares down. Yet Inside Value's valuation-focused strategy pointed out that the company's operations were far stronger than the market was giving it credit for at the time. All that pessimism had provided the opportunity for subscribers to earn a market-beating return.

On the flip side, at the bottom of the list is industrial titan Honeywell. A global leader in numerous critical and largely stable industries, Honeywell is generally considered a boring stalwart and a pillar of stability. Short of a major product recall that it handles in an uncharacteristically poor way, it's hardly the kind of company where emotions would routinely rule the day.

How to profit
Of course, the emotion factor alone won't tell you whether a company is currently over- or underpriced. It will, however, tell you how much the firm's stock has recently moved independently of the expected changes in the true worth of the business behind that stock. The bigger the moves are, the better the chances that the market overreacted because of excessive fear or greed.

If the culprit is excessive fear, you can pounce and profit -- because eventually, emotionally driven price moves eventually do reverse themselves. To take advantage of those emotions, however, you have to recognize when they're ruling a stock's price and know how to act. That's where financial-data-driven analysis can give you the edge. With a firm grasp of what a company is really worth based on its earning potential, knowing when to buy and sell becomes straightforward. It's simply a matter of seeing how far adrift -- and in which direction -- emotions have pushed a stock from its fair value.

The Foolish bottom line
In the stock market, there's real money on the line, with real consequences to real people. As such, emotions run high. If you learn to recognize when investors' emotions have taken control of a stock, you can use that information to your advantage. Simply buy when a sour mood has knocked a company's shares to well below their true value, and then sell when a jubilant one has ratcheted them to well above their true worth.

Are you ready to take advantage of the market's emotional roller coaster? Join Inside Value and learn how to uncover other opportunities to profit from the market's bouts with excessive pessimism. Want more information before committing? A 30-day free trial will cost you nothing more than your time.

This article was originally published on July 10, 2006. It has been updated.

At the time of publication, Fool contributor and Inside Value team memberChuck Salettaowned shares of Fair Isaac. The Fool has a disclosure policy.