Wednesday, September 3, 2008

Value Investing Today: Chp 2: Behavioural Biases: Why Value Investing Works

Value investors need to act and think differently than the average market participant. If they act rationally in a world full of irrational investors, they can expect better than average results. They need to base their decisions on dispassionate objective research. Value Investing works because the majority of market participants continue to make the same errors in judgment and base decisions on biases that are ingrained in human nature. Brandes discusses some of the main emotional biases in this chapter but refers the reader to Dreman, Kahneman and Tversky for a more exhaustive list of cognitive illusions and biases.

Faulty intuition is one cognitive bias that humans use when they try to see a pattern in a series of random events and attribute some meaning to the perceived pattern. Brandes refers to technical analysis as the embodiment of this bias.

Optimism is another bias that value investors need to be aware of when making investment decisions. Brandes references a study done by Dreman, Standard and Poors and First call which examined analysts growth estimates for stocks in the S&P 500 during the time period of 1982 to 2002. The average analysts growth estimate over the entire period was more than 4 times greater than the actual average growth rates observed. Brandes believes the reason for this is that Wall Street analysts get paid to be optimistic!

The third bias is extrapolation. With this bias, market participants place too much emphasis on recent events and tend to project them out into the future. A great example of this is given in the time when stagflation was running rampant in the late 1970's and early 1980's. An expectation of a continued stagflation trend was baked into stock prices. A particularly representative article of the sentiment at the time was the BusinessWeek magazine cover story titled "The Death of Equities" published in 1979. A few years after this article was published, one of the strongest bull markets in history ensued.

All three of these biases lead to overconfidence with investment decisions and set the stage for overreaction by market participants during subsequent surprises. The overreaction to surprises based on faulty expectations is a predictable human behaviour that creates opportunities for value investors.

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