What was Michael Mauboussin trying to tell us by saying to beware of behavioral finance, as he does in the title to chapter fourteen of "More Than You Know: Finding Financial Wisdom in Unconventional Places"?
In previous chapters, he has gone over many of the psychological traits that can trip us up as we try to act as rational investors. The point in this chapter is that we need to be just as thoughtful about our use of behavioral finance as we are about any other strategy or tool.
He began the chapter with a brief review of classical economic theory, which assumed that people would behave rationally if they had perfect knowledge of all alternatives and understood the consequences of their decisions.
Of course, we know that none of us are entirely rational all the time. However, those assumptions did allow previous generations of economists to do research that led to a better understanding of our behavior.
Some economists, recognizing this gap between theory and reality, developed the field of behavioral economics. To bridge that gap, they combined psychology with classical economics. According to Mauboussin, “The goal is to close the gap between how we actually make decisions and how we should make decisions.”
It’s an admirable goal, Mauboussin conceded, but he also pointed out that “poor thinking sometimes sneaks under the behavioral finance umbrella—even by the field’s experts.” To illustrate, he created this syllogism:
- Humans are irrational.
- Markets are made up of humans.
- Therefore, markets are irrational.
It all seems quite logical and straightforward. However, we need to remember that the behavior of investors comes in two forms: collective and individual. The latter addresses how we can avoid being caught in psychological traps, while the former looks at the potentially irrational activities of groups:
“Here’s my main point: markets can still be rational when investors are individually irrational. Sufficient investor diversity is the essential feature in efficient price formation. Provided the decision rules of investors are diverse—even if they are suboptimal—errors tend to cancel out and markets arrive at appropriate prices. Similarly, if these decision rules lose diversity, markets become fragile and susceptible to inefficiency.”
We need not worry about individuals being irrational in this instance, but we should be concerned if too many individuals are irrational, in the same way, at the same time.
Put another way, understanding individual irrationality should help us avoid the psychological traps that could make our own decision making less than optimal. Understanding the dynamics of collective irrationality will help us understand and perhaps outperform the market.
Digging further, Mauboussin noted that experts in behavioral finance understand the role of diversity in moving prices. However, he took exception to this perspective from the experts:
“Since investors are irrational and their strategies are rarely uncorrelated, markets are inefficient. Further, arbitrage is insufficient to bring markets back to efficiency. So inefficiency is the rule, and efficiency is the exception. Active portfolio management in a fundamentally inefficient market is a mug’s game.”
From there, he argued that diverse individuals are responsible for efficient outcomes in many different complex systems, and that, too, is the case in the markets. Further, “Diversity is the default assumption, and diversity breakdowns are the notable (and potentially profitable) exceptions.”
According to the author, the critical question for investors is this: "Are investors diverse enough to generate an efficient market?" His answer was, “If you think across multiple dimensions, including information sources, investment approach (technical versus fundamental), investment style (value versus growth), and time horizon (short versus long term), you can see why diversity is generally sufficient for the stock market to function well.”
So, diversity tends to produce efficient markets—and breakdowns in diversity make the markets inefficient (or more inefficient).
One cause of collective breakdowns is a phenomenon known as herding. It occurs when many investors make the same decisions based on the ideas of others and not on the basis of their own knowledge. Mauboussin wrote, “Markets do tend to have phases when one sentiment becomes dominant. These diversity breakdowns are consistent with booms (everyone acts bullish) and busts (everyone acts bearish).”
Unfortunately, there is no reliable way of measuring investor diversity. Still, as the author noted, “The key to successful contrarian investing is to focus on the folly of the many, not the few.”
In my efforts to understand the content of this chapter, I’ve tried to look at it through the lens of a value investor. From that perspective, I see something of what I expected in the sense that value investing always depends on many other investors discounting the value of a stock without sufficiently considering its overall merits.
Reactions to earnings reports are an example of the herd overreacting to an unexpected gain or loss. When a herd coalesces, diversity in the market is diminished, thus opening opportunities for value investors.
When prices drop too far, value investors will see opportunities and begin buying, which, in effect, brings at least some diversity back into the market. On the other hand, if prices go too high, short-sellers will step in, also returning greater diversity to the market.
I also suspect that diversity in the market may be a driving force behind reversion to the mean, a process that’s akin to a rubber band returning to its original shape once it is released. It appears prices will diverge further from the mean as markets become less diverse and return to the mean as diversity increases.
Conclusion
For those of us who thought we had a grasp on the concepts of behavioral finance, Michael Mauboussin had a surprise up his sleeve: "There is individual behavior and there is collective behavior."
The author has focused on collective behavior in this chapter, explaining that markets are more efficient with greater diversity and less efficient with lesser diversity.
Thus, a value investor has to be a contrarian, looking for bargains in areas where the crowd has become less diversified.
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