Spinning Profits From Errors

 | Jun 25, 2012 | 3:30 PM EDT
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In investing, unlike in many other professions, mistakes can be quite advantageous. For those who disagree, my argument to you rests on the faultiness of the theory of efficient markets. This theory inherently implies that the market makes no mistakes: At any given time, prices reflect all knowable information about a stock. As a result, there is no "alpha" to be made by picking up a stock.

Of course, most of know that this assertion -- the idea that markets are 100% efficient -- is simply not true. Was Facebook (FB) priced correctly when it went public at $38? What about Groupon (GRPN) at $20? Were many stocks priced correctly in late 2008, when everyone simply sold to raise liquidity?  

Every investment transaction involves both a buyer and a seller. The buyer of a stock believes the stock will head higher, while the seller believes that the price is going down. Someone in that transaction will be wrong -- someone will be making a mistake. So, for investors, mistakes should be welcomed with open arms. The key is ensuring that you are not ultimately the one making the mistake. This task sounds simple, but in practice it is very difficult to implement.  

The difficulty lies in what behavioral finance refers to a bias of confidence. Whenever an investor is buying or selling a stock, they are often convinced that their decision is the correct one -- it's the other person who is making the mistake. Such conviction, when based on emotion and opinion, is often faulty. When JPMorgan Chase (JPM) disclosed its $2 billion loss, the market sold off the stock, convinced that this shortfall was just the tip of the iceberg.

What many failed to understand was that JPMorgan was not guilty of taking excessive risk but, rather, that it was guilty of creating a bad hedge. A bad hedge is fixable, assuming excessive risk is problem.  When the shares sold off to $31, shrewd buyers could have taken advantage of the mistake.

Today, the market is selling you shares of Dell (DELL) at $12, Goldman Sachs (GS) at $91, Mosaic (MOS) at $51 and Cresud (CRESY) under $8. Those selling these stocks are looking through a short-term lens that doesn't like the immediate uncertainty surrounding these names. Yet, for each of these companies, the replacement value of their assets vastly exceeds the current market value.  

Mistakes are a natural component of superior investment results. Learn from your own mistakes and then use those lessons to profit of the mistakes of Mr. Market. 

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