The Mispricing Opportunity
Behavioral economics has shown that humans are prone to make mistakes in forming beliefs about the probabilities of future events. We also have inconsistent risk preferences. Analyzing the underlying nature of these mistakes illuminates situations where a biased forecast of the future is being discounted into security prices. Thorpe Abbotts seeks to profit from these situations.
HOW RELIABLE ARE OUR THINKING PROCESSES?
Simple question: A baseball and a baseball bat cost a total of $1.10. The bat costs $1 more than the ball. How much does the ball cost?
If you said $1 and $.10, unfortunately you’re wrong, as there’s only $0.90 difference, but you’re certainly not alone! The correct answer is $1.05 and $0.05 but even Yale students get this wrong.
This was System 1, as author of the seminal book ‘Thinking Fast and Slow’ Daniel Kahneman describes it, your ‘fast’ brain giving you the answer without engaging System 2 which would have done a more considered ‘fact check’ and realized the ‘gut’ response was incorrect!
This mistake is common in investing. At Thorpe Abbotts we are big believers in the use of checklists to prevent investment decisions from falling into the same traps.
‘Thinking Fast and Slow’ author Daniel Kahneman describes how people were stopped on a London street and asked to estimate the cost of a bottle of champagne.
Prior to doing this, they had to choose a single ball from a bag of numbered balls. Unbeknownst to the participants, one bag only contained balls with the number 10 and the other with the number 65.
The people who picked out the number 10 estimated the champagne price to be around £17. The people who picked out 65 guessed at £57 for the exact same bottle! This phenomenon is known as ‘anchoring’ and is widely used by expert negotiators.
A common way this affects how investors misprice assets is in their over-reliance and anchoring on a company’s past growth rate when they forecast future cash flows. Instead of heeding the mean-reverting nature of abnormal growth rates (both high and low), investors simply extrapolate the recent past into the future.
If you got the answer Zuze because your brain recognized the pattern a, e, i and o in the names 1-4 that’s System 1 in action!
System 2 would tell you that the answer is ‘Johnny’ as the opening piece of information you’ve been given is that ‘Johnny’s father has five sons’ and then you’ve been given the other four names.
If you thought the answer was ‘Zuze’ you’ve experienced System 1 doing what it does, looking for shortcuts and recognizable patterns to help you quickly navigate your world. As you can see, it is not always correct! This puzzle appears on LinkedIn from time to time and the comments clearly demonstrate how powerful System 1 can be.
Recognizing patterns where there are none is a key contributor to asset mispricing. Knowing how to look for these types of situations–and exploit them–can be a powerful source of alpha generation.