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Content: Why do we need to make assumptions
about investor mistakes? As we will argue, most investment strategies are
designed to take advantage of errors made by some or all investors in pricing
stocks. Those mistakes themselves are driven by far more basic assumptions
about human behavior. To provide an illustration, the rational or irrational
tendency of human beings to join crowds can result in price momentum –
stocks that have gone up the most in the recent past are more likely to go up
in the near future. Let us consider, therefore, the ingredients of an
investment philosophy. Human Frailty
Underlying
all investment philosophies is a view about human behavior. In fact, one
weakness of conventional finance and valuation has been the short shrift given
to human behavior. It is not that we (in conventional finance) assume that all
investors are rational, but that we assume that irrationalities are random and
cancel out. Thus, for every investor who tends to follow the crowd too much (a
momentum investor), we assume an investor who goes in the opposite direction (a
contrarian), and that their push and pull in prices will ultimately result in a
rational price. While this may, in fact, be a reasonable assumption for the
very long term, it may not be a realistic one for the short term.