Associated Press
- Michael Mauboussin, director of research at BlueMountain Capital Management, asks himself "Who’s on the other side?" in order to identify his advantage in a trade.
- He outlines four key market inefficiencies to reference when determining your edge in the marketplace — and also reveals how to use them to your advantage.
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Every investor wants to gain an advantage over the competition.
But to do so, someone is going to have to win, and someone is going to have to lose. It’s a zero-sum game.
Still, just because it’s difficult doesn’t mean it’s impossible — and one prominent Wall Street guru has developed a method to go about exploiting the market’s blunders.
Michael Mauboussin, director of research at BlueMountain Capital Management, has formulated a way for investors to capitalize on market inefficiencies. And his analysis boils down to a simple acronym: BAIT.
This stands for the behavioral, analytical, informational, and technical lapses that present themselves in the market landscape — and are readily exploitable. And if investors heed his word, they should be able to develop an edge of their own.
First, behavioral.
"Behavioral inefficiencies may be at once the most persistent source of opportunity and the most difficult to capture," he penned in a note titled "Who is on the Other Side?" "The persistence stems from human nature, which does not change rapidly."
Mauboussin attributes the difficulty of exploiting behavioral inefficiencies to the inherent human desire to be part of a crowd.
Think about the asset bubbles of the past. Fear-of-missing-out, greed, and envy were the most powerful drivers of asset pricing, not underlying business fundamentals. Only a tiny portion of price movement can be attributed to changes in fundamentals. After all, 10% shifts in business operations rarely happen, but investors have no problem lopping 10% off a stock price. When fundamentals and valuation divert, investors can capture an edge.
Here’s how Mauboussin says an investor can take advantage of groupthink, over-extrapolation, and emotion:
- Lean on valuation. When sentiment shifts to extremes, valuations follow.
- Err towards facts. It’s important to take the opinions of pundits with a boulder of salt.
- Beware of uniformity. When things seem too one-sided, put yourself on the other side of the argument to confirm or invalidate.
Second, analytical.
"An analytical inefficiency arises when all participants have the same, or very similar, information and one investor can analyze it better than the others can," he wrote.
This notion seems straightforward, but there’s more to the story.
Mauboussin thinks one of the main disparities of the analytical inefficiency comes down to information weighting.
Theoretically, investors should have access to the same information. But the ones who can separate what’s important from what’s irrelevant — and reflect that analysis in their portfolio — will be more successful.
In addition, as new information arises, investors need to update their views accordingly. If the story changes, so should your analysis. An open mind can make a big difference in performance. Never be married to your ideas.
Here’s how to take advantage of information weighting, new information, and changing narratives:
- Write down probabilities of outcomes, and use these as guideposts. Update them when new information arises.
- Understand the story around a stock, and how the market perceives it.
- Avoid putting too much weight on recent moves in the market. Try to encompass a broader story. Recency bias can be detrimental to an investor.
Third, informational.
"An information inefficiency arises when some market participants have different information than others and can trade profitably on that asymmetry," he said.
First mover advantage can increase your odds of investment success — and Mauboussin suggests digging deep to do so.
He continued: "Access to data does not confer an informational edge. An ability to translate data into information, or access to information directly, can be a source of edge."
Here’s how to take advantage of informational inefficiencies:
- Procure information that others don’t have. Leverage customers, suppliers, former employees, and competitors. Dig deep, and look in areas others may not be willing to go.
- All information may not already be priced into the asset. Pay attention to subtleties. Small developments may have large implications.
Fourth, technical.
"A technical inefficiency arises when some market participants have to buy or sell securities for reasons that are unrelated to fundamental value," he said.
Rebalancing, regulatory requirements, and margin calls all fit the bill. These phenomena create forced buyers and sellers — and generate an edge for investors willing to take the other side.
Here’s how to take advantage of technical inefficiencies:
- Pay attention to the leverage cycle, and keep an eye out for forced buyers and sellers. Take the other side when the opportunity arises.
- Watch investor flows. Managers tend to buy more of what’s working.
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See Also:
- A Wall Street stock chief explains how the Fed has brought the stock market dangerously close to disaster — and why rate cuts might be too late to avoid it
- A fund manager who’s crushing 92% of his peers unpacks the blueprint he’s used successfully for 26 years — and shares his advice for surviving stock-market crashes
- ‘Growth stocks in disguise’: Lower rates are supposed to crush bank shares — but one multi-billion-dollar manager says they could explode 10% higher
Source: Business Insider – ccompetiello@businessinsider.com (Christopher Competiello)