"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 -- although with the turmoil in financial stocks lately, you might feel like you've gotten beaten up. 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 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.
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
However, company insiders are now buying shares again, and prospects for high gold prices and a potential surge in copper demand (if a recovery takes hold) have fueled a big rebound. Shares of Freeport are currently up more than 150% from their December 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 bid rigging -- aka 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 the victim of unfair discrimination, simply because it was operating in the insurance industry. Mr. Market apologized for his mistake, revaluing Berkshire shares up 50% to where they stand today.
3. Herding behavior
Any time 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 participating 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 IBM
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.
Marsh & McLennan 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 free 30-day trial to get in on the action.
This article, written by Brian Pacampara, was originally published on Oct. 24, 2006. It has been updated by Dan Caplinger, who owns shares of Berkshire Hathaway and Freeport McMoRan. The Fool also owns shares of Berkshire, which is a Stock Advisor pick. The Fool's disclosure policy has no soft spots.