Portfolio manager’s Letter July 2004
The Efficient Market Hypothesis says that equity markets are efficient and that the current price of a stock represents accurately everything that is known about the company. On the other hand, Jeremy Grantham says, “I believe that markets are usually inefficiently priced, both in detail and in aggregate, and that they are driven by very fallible, emotional investors who have neither the mathematical nor the psychological means to process data efficiently in economic terms, nor, in the case of professionals, the incentive.”
I personally have come to the view that markets may be efficient at evaluating data but are almost always a little psychotic. In this regard Ben Graham’s metaphor about Mr. Market is helpful. Mr. Market knows all the numbers and is perfectly capable of using the numbers to arrive at a logical figure for the intrinsic value of a stock.
The problem is that he is bi-polar and his figure for a company’s intrinsic value is affected not only by the numbers, but also by his mood. His mood changes rapidly sometimes on a daily basis, so his estimate of a company’s intrinsic value changes with the background noise, and that $1.00 in earnings may be worth $20.00 on day one and $15 .00 on day two.
Charlie Munger gave a lecture in 1995 at Harvard University on behavioral economics (“How could economics not be behavioral? If it isn’t behavioral, what the hell is it?”). The title of the lecture was “The Psychology of Human Misjudgment.” Of the 24 factors he discussed, most operate on the subconscious level and have very little exposure to rational thought. Almost all of the factors are involved in the decisions we make when investing money.
The fact is that financial markets are not just about efficient collection of data, but they are also about mob psychology and human emotions. That was obvious to Charlie Munger forty years ago, but has only recently been recognized by financial professionals, and as yet has not penetrated back down to the level of the graduate schools of our leading universities.
… just out of our respective graduate schools, my friend Warren Buffett and I entered the business world to find huge predictable patterns of extreme irrationality. These irrationalities were obviously important to what we wanted to do, but our professors had never mentioned them. This was not an obvious or easy path; I came to the psychology of human misjudgment almost against my will; I rejected it until I realized that my attitude was costing me a lot of money,” From “Of Permanent Value” by Andrew Kilpatrick.
This is not completely true because Ben Graham at Columbia was teaching about ‘Mr. Market’,in the 1950’s. This according to Warren Buffett was one of the most important things that he learned from Graham. This is certainly Graham’s attempt to explain Charlie Munger’s “patterned irrationality.”In the past Warren Buffett has been able to focus of the “huge, extreme” patterns of irrational behavior: closing partnerships in 1969, the teenaged boy in harem market in the late seventies, and of course the granddaddy of all irrationality, the tech bubble.
On a smaller scale it would seem that there was a good deal of irrationality in the price of Coke in 1988 and Wells Fargo in 1991. Warren Buffett and Charlie Munger were practicing behavioral economics 30 years before anyone else had uttered the term.
With all these opportunities for misjudgment, the market may indeed be very efficient at incorporating all that is known about equity, but at the same time there is certainly no reason to believe it is any less efficient at incorporating irrational behavior. Investing money is for most people a very emotional process, and it is easy to pay too much attention to the market. Sell fear and buy greed is a natural human response that causes you sell low — buy high.
Almost all of the irrational behavior we see in the stock market has its roots in Charlie Munger’s 24 rules about human misjudgment. I think the best profit opportunities already have a strong psychological element, and that as the principles of value investing become more widely respected and understood, most descent mispricings will arise from irrational behavior. It seems that every time I see an interview with a investment manager today, the manager says he wants to buy $1.00 for $.50. Value investing has gotten a lot more popular in the last three or four years, and that might be one reason it is so difficult to find undervalued equities in today’s market.
In the stock market, the last thing you want to see is a lot of money doing the same thing you are doing. The more you hear people pushing value investing, the more difficult it will become to make money as a value investor. For me, this means it is time to look for patterned irrationality. So it would seem a good time to review Charlie Munger’s 24 rules.
Number Three on Charlie Munger’s list is an “Incentive – Caused Bias.” This is a huge factor in creating irrational patterns in financial markets, and it exists whenever compensation systems create conflicts of interest. An obvious example is a financial advisor paid by commissions. The pay structure creates an incentive to sell, so the broker or insurance salesman has to develop a bias that allows him to ignore this conflict. This bias affects everyone who works under this pay structure because if the sales person has not developed the bias, they will not be around very long.
For a broker it means he has to present something that the customer will buy and usually the customer wants to buy whatever is hot. So the commission system tends to reinforce the current market psychosis. Decisions made for emotional reasons, and not based on rational judgment. As Charlie Munger says, misjudgments work on the subconscious level, so while the investor thinks he is making a rational decision, what he doing is whatever makes him comfortable emotionally.
Mutual fund managers get paid (and keep their jobs) based on the assets they have under management. But money has feet and comes and goes based on short-term performance or whatever sort of irrational behavior currently infects the people buying the funds. The bias of the fund manager becomes one for doing whatever is necessary to attract funds. This turns the fund manager into an asset gatherer rather than a investment manager.
In all of these cases, the bias becomes a vehicle for transferring irrational behavior from the customer to the market itself. To the extent the bias is in operation, the market is not reflecting the rational judgment of professional managers, but emotions of the individual investor, and the irrational behavior gets transferred upward from the investor to drive the market in very strange directions. So the money gatherers dance to the tunes played by their customers and the irrationality of the less sophisticated seeps into and eventually (as in 1999 and 2000) overwhelms the financial markets.
It seems pretty clear to me that if you want to make money from the financial markets you must learn to recognize these patterns of irrational behavior. Human nature being what it is, financial markets are not likely to get more rational in the future. Many of the largest and most tradable inefficiencies in the pricing of stocks are likely to be found in the area of human misjudgment.