Back To Basics: Value Investment And Behavioral Economics by Balint Anton Francisc
Today’s financial markets are bombarded with a long list of worries. Some of which are more justifiable than others. As Howard Marks suggests in his first memo for 2016, On the couch, the list includes fears related to China’s economy, the inability of central banks to achieve 2% inflation, the geopolitical picture in Syria and the flow of immigrants in Europe, ISIS, the oil price ‘up and down’ movements, the US political election and Brexit.
How can investors make sense of the ‘new’? Are all these events truly unseen? Is still sensible to be a conservative investor in such a chaotic environment? As Frank Lin puts it in his article, ‘You don’t need to be the smartest guy in the market, but rather you have to develop a contrarian view about how to interpret stock market.’ – Frank’s article is also a very rigorous reading list that is essential to any investor that looks to invest for the long-term (it even includes the elusive book written by Seth Klarman, Margin of Safety). Nevertheless, the contrarian view needs to be developed in a manner that contradicts the market the right way and for the right amount of time – otherwise you are either too early or too late to profit from market anomalies.
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This article aims to restore our common sense in looking at the financial markets. It tries to do so by bringing in the field of behavioural economics. All generations deal with uncertainty and unforeseen events that damage or boost their economies. However, thankfully we have now a much larger body of data regarding how we perceive and deal with such events. This data is constructed under the umbrella of Behavioral Economics.
Behavioral Economics – An Introduction
The field of behavioral economics is defined broadly as the subject that aims to improve and deepen our understanding of behaviors of those that engage in financial markets and make decisions that affect our economies by blending insights from psychology and economics. The important element is psychology, as Charles Munger noted many times. More specifically, behavioral economics looks at behavioral psychology, cognitive science, personal theory, social psychology and evolutionary psychology in order to highlight why we act the way we do in the sphere of economics (for the purpose of simplicity, economics will include both financial markets and their actors and economic theories based on mathematical formulas).
Historically, this field was not clearly defined and it was put together throughout centuries. For example, we have David Hume in A Treatise of Human Nature (1739) looks at economic psychology from the moral dimensions of decision making. Moreover, Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations (1776) describes his thoughts regarding the socio-psychological motivations and the role of feelings (emotions) in economics. Earlier influences include: John Maynard Keynes in his General Theory of Employment, Interest and Money (1936) argues that economic and financial decisions are driven by a series of ‘fundamental psychological laws’, including the propensity to consume, attitudes to liquidity and expectations of returns from investment.
Nevertheless, we have now a more stable basis for behavioral economics. As Michelle Baddeley in Behavioral Economics and Finance (2013) suggests, one of the most powerful influences on our learning is the social influence: when we learn about different events, we treat others’ actions and experiences as a source of information. In addition, we are prone to be influenced by normative forces such as social pressure and social norms. Finally, groups and others’ psychological development (behavior and set of believes for example_ affect our own identity. This final point is very important because identity is who we think we are and as a result, it is the driver for our most profound actions.
Now let’s connect the dots: where does value investment come into play?
Back to basics – Value Investors in the age of uncertainty
Now that we are aware of a few factors that makes us more vulnerable to the events around us and especially to take action based on how others do it, what can we do to ensure that we invest conservatively and mitigate total capital loss?
Firstly, we should reason from fundamental principles. This is a method used by physicists and suggested by Elon Musk, the CEO and founder of Space X and Tesla Motors. What it involves, in general terms, is to take a step back and reason from general truths. This is how I do it: the market volatility and all the events that turn prices to red and green are irrelevant in short-term because No.1 we have a limited number of markets to invest in, No. 2 these markets still need investment, regardless of predictions and fears (Africa still needs a lot of money being put into infrastructure and China still has to receive substantial capital in order to support its transition economy – just two examples), No. 3 there is a limited amount of capital that we can invest driven by a limited amount of resources – this results in cycles but not in permanent price movements and No. 4 we need to look at the long-term goal of capital allocation: to create value (only value will ensure you profits for years to come).
Secondly, we can choose from whom to learn and who to follow. If we cannot escape the psychological need to follow others, why not cheat it? Let’s take the interest rate spectacle as an example: we have seen the Fed being hawkish and the ECB being dovish and yet, interest rates are still very low thus justifying very high valuations of equities. In other words, how can we make sure we do not over pay for the shares we buy? Well, why not look at one of the greatest minds in the investment profession’s history, Warren Buffett, for suggestions instead of listening to cohorts of analysts contradicting themselves? Warren Buffett, in 2009, speaking for the Time magazine stated:
‘The formula for value was handed down from 600 BC by a guy named Aesop. A bird in the hand is worth two in the bush. Investing is about laying out a bird now to get two or more out of the bush. The keys are to only look at the bushes you like and identify how long it will take to get them out. When interest rates are 20%, you need to get it out right now. When rates are 1%, you have 10 years. Think about what the asset will produce. Look at the asset, not the beta. I don’t really care about volatility. Stock price is not that important to me, it just gives you the opportunity to buy at a great price. I don’t care if they close the NYSE for 5 years. I care more about the business than I do about events. I care about if there’s price flexibility and whether the company can gain more market share. I care about people drinking more Coke.’ – Bold was added by me.
Finally, depending on what you are, a hedge fund manager, a retail investor etc., look to understand the relevant factors that impact your money – if you manage a hedge fund that employs structured products and algorithm trading, you will consider different factors in managing your portfolio than if you invest based on fundamental valuation and ‘field analysis’ (inspecting the goods). Psychological biases don’t have to put you off from taking the risk of investing in innovative and new businesses but they have to be always in your mind when you make decisions. I wholeheartedly recommend the memo from Howard Marks mentioned at the beginning of the article as it summarizes the entire process of dealing with the current events in a ‘courageous and cautious’ manner.