Behavioral investing is one of the most exciting aspects of the investment landscape. Learning how investors (myself included) handle certain situations and what we can do to stop knee-jerk reactions is vital for understanding how to be successful in the markets over the long term.
Seth Klarman (Trades, Portfolio), a highly regarded value investor and portfolio manager at the $30 billion hedge fund Baupost, seems to have the same view. According to him, understanding how investors behave is much easier than trying to predict the earnings potential of a company.
A key to successful investing
"Understanding how our brains work—our limitations, endless mental shortcuts, and deeply ingrained biases—is one of the keys to successful investing. At Baupost, we believe that it is sometimes easier to predict how investors will behave in certain situations than it is to predict a company’s bottom line. At times of market extremes, by avoiding emotional overreaction and remaining aware of our biases, it may be possible to know market participants better than they can know themselves."
Over the years, Klarman has shared advice on how to be a good investor and refining investment processes. This particular quote, however, gives us even greater insight into his process. It is notable that he believes it is sometimes easier to predict how investors will react in certain situations than it is to analyze businesses.
Klarman has spent more than three decades analyzing businesses and searching for value around the world, so he knows a thing or two about how to find undervalued companies. He has also, unlike many other hedge fund managers today, been through some of the most aggressive bear markets in recent history. This means he has a robust understanding of investor psychology and how investors react during periods of market stress. This understanding undoubtedly gives him an advantage over other market participants during bull and bear markets.
Even though the market is full of highly intelligent individuals who work for some of the most prestigious financial institutions in the world, it is still dominated by human emotion. People like what is fashionable, trendy and exciting. They also dislike what is boring, out of favor and stigmatized. Understanding these emotions and what drives them is all part of determining why assets have underperformed.
Many investors lack the courage and stamina to stand apart from the herd, unable to tolerate short-term underperformance to reap long-term rewards. I don't think it is, therefore, possible to eliminate these human emotions from our psyche. They are, after all, behavioral biases that have developed over thousands of years.
Just by knowing these biases exist, however, is enough to keep them in check. Knowing and understanding your own weaknesses is the first step on the path of keeping emotions under control, which is vital in investing.
Emotions under control
This is what Klarman seems to be suggesting in the quote above. While it will never be impossible to eliminate deeply ingrained biases from our minds, understanding how they work and impact our decision-making is critical if we want to limit their impact on our day-to-day trading activities.
Even if we know everything there is to know about a business and have calculated its intrinsic value accurately, if we do not have a handle on deeply-ingrained mental biases, which may cause you to make a mistake, this analysis may go to waste.
In other words, detailed financial and fundamental analysis of companies is only part of being a successful investor. You also have to have a deep understanding of yourself as well.
Read more here:
- Using Michael Porter to Find Good Businesses
- Klarman: Find Your Edge and Stick to It
- Charlie Munger on Envy and Jealousy
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