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Finding the edge

In the first of our new ‘Further Reading’ series, Alex Newman looks at Michael Mauboussin’s recent research on market inefficiencies
April 25, 2019

What edge have you got as an investor? A good answer to that question is a requirement of any trade, according to Michael Mauboussin, current director of research at BlueMountain Capital Management and former head of global financial strategies at Credit Suisse.

In his recent paper Who is on the other side?, Mr Mauboussin frames the notion of edge in negative terms, by proposing a “taxonomy of the sources of inefficiency”, which is another way of describing the many ways in which markets fail to properly reflect all available information through asset prices.

In doing so, Mr Mauboussin distinguishes between the market for information and the market for assets, and starts from the basis that neither can be entirely efficient.

Here, he draws on the work of economists Sanford Grossman and Joseph Stiglitz, who argue that the cost of acquiring information to determine the price of an asset shows that prices cannot perfectly reflect asset value (see chart below). If they did, there would be no incentive to invest. Indeed, the fact you are reading this could be held up as a demonstration of this inefficiency; preparedness to pay for a magazine about investing suggests the belief in the possibility of excess returns.

“The main point,” Mauboussin writes, “is that it is reasonable to think about efficiency, a state where price equals value, as falling along a continuum from very inefficient to very efficient.” Active investors need both inefficiency and efficiency. The former creates opportunities, while the latter turns these opportunities into returns.

 

 

Rise to the BAIT

Investors need to be alert to four strands of inefficiency, argues Mr Mauboussin. These are behavioural, analytical, informational and technical (BAIT), categories which investor and asset manager Patrick O'Shaughnessy neatly characterised as a “supply of error” in a recent interview with the paper's author.

Behavioural inefficiency concerns the way collective investor sentiment causes price and value to diverge. Although behavioural finance is a relatively young field of study, it has echoes of the writings of legendary investor Benjamin Graham, who expressed the concept through the character of ‘Mr Market’; a metaphorical actor who generally offers investors sensible prices, but who is prone to bouts of wild swings in optimism and pessimism.

A classic illustration of Mr Market at work can be found whenever Warren Buffett, perhaps the most renowned follower of Mr Graham’s principles, discloses a new stock position. The moment a holding is made public, investors invariably pile in behind the Sage of Omaha, regardless of what the companies themselves have done, and without any change in the underlying value of the business.

Such inefficiencies are evident on a larger scale, too. Mr Mauboussin cites a 2013 study by financial economist Bradford Cornell, which found that only a minority of the 50 largest moves in US stocks in the last 25 years could be “tied to fundamental economic information that could have had a pronounced impact on cash-flow forecasts or discount rates”.

Behavioural sources of inefficiency are most apparent when investor beliefs coalesce around a certain view, and begin to “push price away from value”, concludes Mr Mauboussin. The classic demonstration of this is the close correlation between the change in earnings performance of a stock over the past year, and investors’ future earnings expectations. Research suggests pension sponsors are hardly immune to such whims, and tend to hire and fire investment managers at the wrong time, in reaction to recent performance.

This so-called ‘performance chasing’ should be distinguished from momentum investing, which Mr Mauboussin sees as a more rigorous strategy. By extension, because over-extrapolation is an inbuilt human trait, the flip side to the prevailing (or popular) market views are therefore always worth examining.

 

Well behaved

But escaping investor behaviour that tends towards inefficiency is no easy task. Mr Mauboussin says that the process of belief formation itself – that is, coming to an investment decision – is highly susceptible to three forms of overconfidence: overestimation, overplacement and overprecision. Put simply, these are an individual’s inflated sense of absolute ability, relative ability, and accuracy. Even portfolio managers are guilty of wildly overestimating their confidence levels.

Still, knowing we’re often overconfident isn’t much of a guide to knowing when we are being overconfident. One way to think of this, says Mr Mauboussin, is to check for the concomitant symptoms of rising asset prices and heightened trading activity, both of which are closely associated with misplaced confidence.

Apparently – who knew! – journalists are also equally guilty of this tendency. A 2007 study of cover stories featuring businesses in the Financial Analyst Journal found that “positive stories generally indicated the end of superior performance and negative news generally indicates the end of poor performance”.

 

The diversity premium

The presence of overconfidence alone doesn’t create an inefficient market. Indeed, a market with overconfident buyers and sellers on both sides creates a heterogenous, diverse, and therefore wise crowd. But crowds tend to go mad (and thus inefficient) once investors all start to follow the same rules and think alike.

Citing research into models in which simulated traders interact, learn from and adapt to one another, Mr Mauboussin highlights two important lessons about behavioural inefficiency.

The first is that once traders start to behave like one another, they initially tend to get richer, “as positive feedback pushes price away from value and creates lots of paper gains along the way”. Second, Mr Mauboussin points out that crowded trades and a herd mentality create market fragility, even as “a higher asset price obscures the underlying vulnerability”, all of which increases the inevitability (and severity) of a sharp correction. Betting against bubbles is often a thankless task.

Simulations are well and good, but key to understanding the spread of collective belief is establishing when diversity falls apart. Mr Mauboussin points to both the dotcom boom and Bitcoin as examples of such breakdowns, ones in which “new investors (commonly individuals)... buy an investment or investment theme”, and seasoned investors “stop betting against the investment or investment theme”, thereby removing any countervailing opinion.

Cutting through the behaviour-driven noise is no easy feat. But Mr Mauboussin reckons the best advice might still be Mr Graham’s call for investors to “have the courage of your knowledge and experience, and to act on conclusions even though others may hesitate or differ”.

 

Analytical self-awareness

Having the courage of your convictions may be a worthy lesson, but a survey of the academic literature has a tough lesson for ordinary investors: time and again, institutions tend to make for more rigorous, practiced and effective analysts.

One of the key contributors to this disparity in analytical edge is how an investor weighs information. Here, Mr Mauboussin distinguishes between “the strength, or extremeness, of the evidence, and... the weight or predictive reality”. A strong first-quarter sales performance, or a recent dip in a commodity price, might feel like a strong signal, but strong signals are not the same as strong evidence of a long-term trend, and often lead to overconfidence or overextrapolation.

Mr Mauboussin also unpacks the related idea of overreaction, which is closely associated with the 'contrast effect'. This is investors’ tendency to see good news as somehow more impressive when it follows bad news, and less impressive than it should be it if follows good news.

But the paper’s most interesting reflections on analytical edge are those which blend behavioural sources of inefficiency. Mr Mauboussin points to John Maynard Keynes’ observation that a professional investor’s skill is less to do with “making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing change in the conventional basis of valuation a short time ahead of the general public”, than adopting a long-term stance of reflection and judgement.

These latter qualities, Mr Mauboussin suggests, are often overlooked or washed away by short-term analytical impulses. To demonstrate this, he cites nearly a century of US stock market data which shows that the longer an investor leaves their portfolio, the greater the chance they will see a profit upon inspection. In the short term, markets are unpredictable and volatile, and after a day, the chance of seeing a profit is around 51 per cent. But after a decade, this probability rises to near 100 per cent.

It follows, then, that the more frequently an investor checks their portfolio, the more likely they will suffer from loss aversion, and trade more frequently. By extension, a long-term and patient approach to investing also helps to lift returns by amortising the information gathering and transactional costs over a wider time period.

 

Informational asymmetry

Even if institutional investors have more labour power, skill, liquidity and resources, it’s sometimes tempting to think of investing as a level playing field. After all, disclosure rules mean all market actors have to digest earnings reports at the same time, and the cost of access to this information is falling all the time.

Not so, says Mr Mauboussin, who points to a raft of ways investors can obtain an informational edge. The first is to legally acquire information that others do not have. While obvious, this is easier said than done. Hedge funds spend huge amounts filing Freedom of Information Act requests to source non-public information about drug trials, paying for satellite images of mines, or hiring lawyers and political consultancies for expert opinion. Other investors advocate the 'scuttlebutt' approach to gathering public and non-public information from suppliers, competitors, customers and former employees to create a mosaic view of a company that differs from the prevailing view.

However, this is expensive and often difficult work. But investors can still get an information edge by paying more attention to public information. Mr Mauboussin cites evidence that the cost of attention means inefficiencies are inevitable, and that it is therefore important for investors to “recognise that not all information is immediately reflected in prices”. By extension, the more complex the information, the slower its absorption by the market, and reflection in prices.

 

Forced sell-offs and flows

Mr Mauboussin’s last category of inefficiency – technical – is probably the most esoteric, and hardest to put into practice.

But within his comments are some broad lessons. His suggestion that investors should always be on the lookout for market participants “compelled to buy or sell securities without regard for fundamental value” is sage advice, even if this is very hard to determine. Watching for trading volume – via inflows or outflows – is also a way to anticipate repeat trading buying, or forced selling by fund managers.

Whether technical edges are also informationally asymmetric – that is, can be seized upon ahead of other market actors – is of course another question. But Mr Mauboussin’s overall idea – that any investor can build their edge by better understanding inefficiencies in all their forms – is nonetheless important, as is finding game-like investment opportunities in which “there is differential skill and you are the most skilled player”.

 

For more on Michael Mauboussin’s insights into behavioural finance, see Tom Dines’ review of More Than You Know (2007) in this edition of the IC Book Club