Investor psychology: the gift that keeps giving
Give a man a fish, you feed him for a day. Teach him to exploit investor psychology and you feed him for a lifetime.
Ever noticed those card shuffling machines blackjack dealers use? They're there because of Edward Thorpe, the father of card counting.
Thorpe was the first to prove mathematically that a player could get an ‘edge' over the house by counting cards. A generation of card counters followed with a simple process: calculate when a deck is stacked with tens and aces, which skews the likelihood of success to the player, and then bet heavily.
The trouble is that casinos eventually introduced countermeasures, like shuffling machines and unfavorable blackjack rules, so that the profits made by Thorpe and others are impossible in most casinos today.
Thorpe's blackjack strategy is similar to an intelligent investing process: investors should also wait until they have an 'edge' and then they should bet heavily.
But just like Thorpe's blackjack edge, investing edges come and go. Finance students are taught about 'arbitrage' – the process of making riskless profits trading the same security in different markets – but computers killed those long ago. Even value investing is becoming a crowded space.
But there's one source of edge that will never dry up: investor psychology.
Mr Market served up opportunities 70 years ago and he'll be doing so in 70 years' time. That's because stock prices are influenced by humans, and we're all emotional, irrational beings.
A process engineered to identify psychological shortcomings, and then exploit them, could be a winning long-term strategy.
For example, Australian investors love their dividends and the franking credits they deliver, but all hell breaks loose when dividends are cut. It could be that sifting through ‘dividend disappointers' is a good place to find bargains.
We've all become accustomed to instant gratification these days. Netflix and social media give us instantaneous entertainment and connectivity. It's no surprise that we've also become short-sighted with our investments. Extending our own investment horizons, by buying businesses that are investing for distant payoffs or those with problems that will take years to resolve, could be a way to exploit that.
Another area could be low-quality companies. I can't think of a single investment fund that seeks to buy bad businesses, but I can think of dozens that buy 'high quality'. But investing is less about assembling a group of good businesses and more about identifying mispricings. And if most investors are fighting it out for 'quality' then discarded companies could be overlooked.