How Irrational Investors Can Set You Up for Logical Gains

Do you know of Richard H. Thaler? If not, you should. Chances are if you’re reading this post, you are curious about the stock market and making money.

And if you’ve got just a smidgen of curiosity about those subjects, that interest will be piqued by the idea that unique buying and selling opportunities in the stock market are created every single day due to a quirk in economic theory.

Richard Thaler is an economist at the University of Chicago Booth School of Business, who was awarded the Nobel Prize in Economics last week for his work uncovering this snag in the fabric of asset valuation.

He exposed gaping holes in most of the economic theory that underlies the basic tenets of stock valuation. That tear, which he brilliantly quantifies in his research, is the human mind and its tendency to behave irrationally.

The problem, you see, is that most economic theory is predicated on the idea that human beings base economic decisions on rational thought. Although it makes obvious sense to any parent who has attempted to dissuade a teenager from spending $200 on a pair of flimsy shoes, the irrational mind is a new input for economic modeling.

“The fact that people are human is only interesting if uttered by an economist,” Prof. Thaler said when Wall Street Journal reporter Jason Zweig spoke to him last week. “It’s obvious to everybody else”. However, a few decades ago among economists, “it was a verboten topic, and you took a lot of [grief] for saying it.”

Economic theory always held that more information is always better and that the more data and more options offered to a consumer, or in this case, an investor, the more likely he or she would make the best choice.

This thinking is part of the foundation of the Efficient Market Hypothesis. This theory states that it is impossible to “beat” the market because asset valuations adjust almost immediately to absorb new information.

A rapid adjustment to asset values is certainly quite possible in today’s breakneck speed internet dissemination of information. I won’t tip you off to how old I am, but as a young analyst, we would wait for the mail carrier to deliver a stack of recently issued 10-Qs from public companies to scour for new footnotes or qualifying language that might move a stock.

And yet, Mr. Thaler’s work seems more relevant than ever. Investors are nervous about tip-top valuations and how those valuations will fare in light of higher interest rates. It seems impossible to separate the emotional investor from the rational one.

Behavioral economics, which lies at the intersection of psychology and economics, is a less explored region of economic study. The press release announcing Mr. Thaler’s award describes his “contributions to behavioral economics” as follows:

“By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes.”

Mr. Thaler specifically noted three human traits that interfere with logical, efficient investment decisions.

Limited rationality, where investors have a disproportionate aversion to losses or silo gains and losses into separate mental accounts, is a trait that can impede rational decision making.

Lack of self-control, an obvious and common human foible, can wreak havoc on an investing plan.

And finally, social preferences, which deal primarily with the fairness regarding pricing, can upend the expected economic outcome of a situation.

As an analyst who specializes on short-selling, I’ve spent the bulk of my investment career searching for these pockets of dysfunction in the stock market. I can tell you first hand, Mr. Thaler’s research is absolutely true.

Countless times, I’ve watched the value of a stock double or triple with little economic data behind the move. I often feel more like a psychologist than analyst trying to predict what event or data point will reverse the bullish halo that surrounds some stocks.

It’s an art, not a science, to pinpoint these shifts. Over the past 30 years, I’ve refined my sixth sense for discovering irrationally priced stocks and timing the change in mood that will revert them to the mean. It’s not always right, but I think it’s pretty good.

In my Profit Catalyst Alert newsletter, I’m always on the lookout for mispriced securities, both long and short. Please consider subscribing to hear about these recommendations.

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