Portfolio manager’s Letter October November 2004
Behavioral finance is a relatively new field that attempts to study financial markets on the basis of the psychology of the participants. 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 assessing the risk involved in any common stock investment is a function of the volatility of the stock involved. In other words, if the price of a stock moves big in one direction or the other on a regular basis, it carries a higher average risk as an investment.
Charlie Munger on the other hand regularly refers to this method of risk assessment as “twaddle.” This is hardly an academic debate, because nothing is more important to the investor than being able to properly understand the risk involved in any kind of 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 investment is one that minimizes the risk the investor faces, and that pays you well for taking the risk. All investments decisions should start by measuring risk.
If we are using “Beta” (Volatility) to estimate the risk 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 a concept “that is perfectly obvious but very little understood.”
Were 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 markets are bipolar. So risk 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, 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 as it lowers the price of the stock and helps to reduce the risk that comes with a purchase.
Another factor in determining risk 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 is an indication that Mr. Market is currently suffering from depression and that his normal optimism is currently in remission. Once the onslaught of bad news has slackened, the large short position will help to fuel a rally in the stock.