Inefficiency 3 - Behavioral

Behavioral: Behavioral inefficiencies are the hardest to take advantage of because we have our own behavioral biases that we have to cope with. It is not easy to buy a security that has been declining in price significantly because you are afraid someone else is selling it to you because they know something you don’t. However, the most money in the market is made because of behavioral inefficiencies. This is why Warren Buffett has said that the most money is made by those with the strongest stomach not those with the highest IQs.

Behavioral inefficiencies come in many forms but the most common are caused by fear, greed, and career risk.

Fear causes stocks to sell off more than they should in downturns because people are afraid of losing more money. How many times have you cut an investment loose simply because you can’t take the pain of losing money any longer? It is simply human nature. We start to think about “if I lose any more I’m going to have to tell my spouse about this,” or “if I lose any more we aren’t going to be able to go on that vacation we planned or do the kitchen remodel we wanted”. These are very real emotions that take place when an individual stock is down, often creating a snowball effect where selling leads to lower prices, which leads to more selling and lower prices. This is why market corrections happen incredibly fast, while bull markets are much more gradual.

Greed causes stocks to go up past their intrinsic value because people don’t want to miss out and they lose all sight of risk. Your neighbors have made 5x their money on a hot tech stock. You are smarter than they are and yet they are making all this money. It must be really easy then, time to jump in before you miss out on the next big gains. Greed is driven by envy more than anything else.

Charlie Munger once said envy is the stupidest of the deadly sins because it is the only one in which you get no benefit and you also feel horrible. But, envy is a powerful thing. The late 90’s tech boom serves as a great example. In the last few years leading up to the collapse it seemed like every day stocks were going up. IPOs were coming out and doubling in the first trading session. People who weren’t making money felt left out, envious of their friends and colleagues who were getting rich, and wanted in on the action. Making money seemed so easy that people threw all caution to the wind and wanted more. Individuals whose companies had come public and become multi-millionaires overnight took their winnings and bet even heavier on other tech darlings. This pushed prices significantly beyond the intrinsic values of these companies, which eventually led stock prices to come crashing down.

Career risk drives market inefficiencies because most of the money managed in the stock market is conducted by someone getting paid to invest someone else’s money. If a fund manager doesn’t keep up with the market, or if he has a bad year, bad quarter or sometimes even a bad month, investors may pull their money and it could cost the manager his job. This drives many managers to have portfolios which closely resemble the overall market, even if that means holding certain securities the manager believes are overvalued.

Career risk also drives a behavioral inefficiency caused by differences in investment time horizon. Managers worried about their jobs are focused on short-term performance over weeks, months and quarters rather than years. If an analyst is looking at a company and only evaluating the next few quarters and not evaluating how the company will develop over the next few years, there will be opportunities created for investors with longer time horizons.

How We Take Advantage of Behavioral Inefficiencies

Candidly the most important thing is to look inward and identify our own behavioral weaknesses (we certainly have them). We structure how we operate the portfolio around understanding our own weaknesses. As an example for each security we have a price at which we will buy and price at which we will sell, assuming the business hasn’t changed. We put those prices in writing and we stick with them. That way if a stock goes up very quickly and reaches its fair value we don’t allow ourselves to get greedy and hold on to capture more upside. Alternatively if a stock goes down and we start feeling upset, we have preset levels where it makes sense to buy more if the business hasn’t changed.

By doing this, we take advantage of other people’s emotions and don’t let our own cloud our decisions. Those “price targets” are backed up by detailed internal memos where we cover (i) the business and its prospects, (ii) the management team and (iii) the company’s valuation. When a stock starts dropping, having that memo where you have dispassionately outlined the case for owning the business is critical.

We do the same thing for a large number of securities that we don’t own and are on our “watchlist”. We tend to set price targets well below current prices because we want to buy the business at a price that is cheap enough that even if we have made mistakes in our valuation we can still make money. When the stocks on our watchlist start to approach our price targets, we revisit the business to see if anything has changed and we start putting together one of our detailed memos. This helps us to ensure that we are buying at a good price and have some “emotional support” in terms of the dispassionate analysis (memo written before we bought it) if the stock keeps going down after we own it.

The biggest advantage we have from a behavioral aspect is an incredible base of partners who are long-term oriented and not focused on next month’s performance. This allows us to not worry about career risk, and take a longer investment horizon. Our longer investment horizon allows us to capitalize on opportunities where other market participants need immediate liquidity or are looking at a businesses on a 1-2 month basis rather than a multi-year basis.