Portfolio manager’s Letter October November 2004
Behavioral finance is a relatively new field that attempts to study financial markets based on the participants’ psychology. It is a bizarre world in which nothing is as it appears. A business where good news can be dangerous and bad news is not necessarily bad. The older and more widely accepted Modern Portfolio Theory teaches that risk assessment of any common stock investment is a function of the stock’s volatility. In other words, if the price of a stock moves big in one direction or the other regularly, it carries a higher average risk as an investment.
On the other hand, Charlie Munger regularly refers to this method of risk assessment as “twaddle”. This is hardly an academic debate because nothing is more important to the successful investors than properly understanding the risk involved in any potential investment. There is, after all, risk in all investments. Even the supposedly safe stuff like bonds and CDs face interest rate risk and periods where your return is eaten by inflation. A good risk assessment minimizes the risk the investor faces, which pays you well for taking the risk. All investment decisions should start by measuring risk.
If we are using “Beta” (Volatility) for risk assessment of an investment, and if it is, as Charlie Munger says, “twaddle”, then our chances of making a good investment are slim. Charlie Munger would say that value is a better gauge of risk. An overvalued stock carries more risk than an undervalued one. This is a rather simple concept or, as Charlie Munger would say, an idea “that is perfectly obvious but very little understood”.
Where established wisdom says that markets are efficient and all price movements represent rational indications of value, behavioral finance will throw in with Benjamin Graham and accept the premise that needs are bipolar. So the risk assessment is dependent to a large extent on current investor psychosis. Strong bullish sentiment driven by good news makes a market more dangerous. At this point, the process of valuing risk becomes counter-intuitive. The more the price of a stock goes up, the more risk it carries.
Many investors will watch as good news drives the price up to and buy once a comfort level has been reached. But while good news may make the investor more comfortable, the truth is good news is bad because if the price is going up, so is the risk level. Assuming the balance sheet is strong, and you like the business, then bad news is good because it lowers the price of the stock and reduces the risk that comes with a purchase.
Another factor in risk assessment is the level of speculative short positions in the stock. Again, this factor has nothing to do with the volatility of the stock and is counter-intuitive. Having a lot of speculators with short positions in the stock would, on the surface, seem bearish, but the large short positions are a sign that the stock is oversold. This, in turn, indicates that Mr. Market is currently suffering from depression and that his normal optimism is presently in remission. Once the onslaught of bad news has slackened, the large short position will fuel a rally in the stock.