In the previous chapter, Jeffrey C. Hood explained how investors might take advantage of a market or macroeconomic crisis. Now, in chapter ten of “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd”, he has suggestions that can help us stay safe during market bubbles.
He wrote, “In considering the scenario of unbridled optimism, where stock prices advance well beyond their intrinsic values, knowledge of valuation principles and the Foolishness of the Crowd will be of great benefit. The two defenses of: 1) knowledge of valuation principles and 2) knowledge of market psychology enable the investor to avoid falling into the trap of participating in a market bubble.”
More specifically, when investors know and understand valuation principles, they are more likely to stay rooted “in the facts of intrinsic value”, which helps them avoid being caught up by a greedy crowd. Knowing about market psychology helps them recognize that the foolishness of the crowd is likely a reason for inflated valuations.
He makes a further, interesting, comment on the valuation aspect; as the stock price gets close to the intrinsic value, the margin of safety disappears. At that point, the potential for future returns is no longer about the gap between price and value. Once price rises above the intrinsic value, investors are depending on the hope that the market will drive prices further above the intrinsic value. That, of course, is the “greater fool” theory or speculation.
Hood does make an exception for investors who want to keep compounding their book values, by staying invested in great companies with great rates of return. However, investors who find themselves speculating after the price reaches intrinsic value should seriously consider selling, or at least liquidating part of the position.
But, having liquidated or eliminated a stock that continues to rise subjects investors to temptation, to jump back into the market by repurchasing the shares they sold or other stocks. That happened to one of the greatest minds ever, Sir Isaac Newton. The South Sea Trading Company continued to keep going up after he first sold out at a profit. As the price continued to go up, amid all the hype, Newton jumped back in at a higher price. Shortly afterward, the bubble burst, wiping out all of Newton’s earlier profits and his position altogether.
We can all learn from Newton’s example, by keeping intrinsic values constantly in mind and maintaining our discipline. That lesson is even more important now, when selling triggers the payment of taxes, leaving us with less capital to subsequently invest. For example, we might be buying back in with 75-cent dollars.
And, as mentioned, there is also the compounding issue. Investors would want to make a distinction, in advance, of which companies are long-term holds and which are not. For example, a cyclical stock purchased at the bottom of a cycle would not be a good compounding stock.
Hood also reminds us we need to consider the issue of holding cash as a market becomes overvalued. That’s difficult because it involves timing the market, which is never psychologically easy. In addition, there is an opportunity cost that can become excessive if the next major decline takes longer to appear than expected.
Turning to crowd psychology, Hood explained, “A stock market bubble is largely a product of 'get rich quick syndrome' and greed, with a number of other psychological effects as contributing factors. A good understanding of these factors and how they interact to cause such large-scale irrationality will provide the investor with good ammunition to avoid following the crowd.”
Delving further into the issue, the author raised the issue of risk—in its two forms. First, there is what he calls the conventional wisdom in academic circles that risk is the same as volatility. Hood pointed out that there are several problems with this definition; most importantly it does not allow for the fact a company can have a stock price that is not the same as its intrinsic value.
He added, “If one accepts the fact that a business CAN have an intrinsic value that differs from its stock price, and that stock prices eventually gravitate towards their correct intrinsic values over the long term, then the entire theory of volatility as risk necessarily fails, since past volatility tells us nothing about whether a security is currently mispriced.”
He went on to quote Warren Buffett (Trades, Portfolio), who wrote, “The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability -- the reasoned probability -- of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a nonfluctuating asset can be laden with risk.”
Given that a stock market is a weighing machine in the long run, as Benjamin Graham put it, then “perhaps the greatest risk that an investor can have is to NOT consider business valuation as the cornerstone of his investment approach.”
In practice, Hood argued there are two risks of concern to investors. First, there is the loss of money or purchasing power. Second, there is the risk that they will miss opportunities and not make as much money as they think they should.
The primary method of reducing the risk of losing money is by demanding a large margin of safety. Turning to the risk of not making as much money, Hood saw a couple of trade-offs. By holding fair or overpriced securities, investors are trading off one risk for another, the potential of losing money versus the possibility of not making as much money as expected. The second trade-off involves opportunity cost, the price of getting out of the market too early.
Finally, he noted that his book offered a third way to manage risk, by understanding both the wisdom and the folly of the crowd, “the investor who consistently bases his decisions on the presence of an inefficient rationale will have less risk in his investment decisions, i.e., less chance of being wrong.”
Conclusion
In chapter ten, Jeffrey Hood stressed the importance of knowledge, of proper valuation and of market psychology, to avoid being sucked into a market bubble.
That also involved a discussion of risk, of losing one’s capital or missing out on the gains possible as a market heats up. Again, the importance of valuation and market psychology stand out as tools of protection.
It is all part of the fabric in Hood’s theory of inefficient markets.
Read more here:
- Inefficient Market Theory: Bargains in a Market-Wide Crisis
- Inefficient Market Theory: Berkshire Hathaway and Indexation
- Inefficient Market Theory: Wells Fargo and the Subprime Crisis
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