PM Thoughts: Empathy
Empathy is an extremely under-discussed and underrated skill in investing.
How many times have you said: “This valuation is crazy!”
Usually, the next sentence that comes is “Market is being stupid / irrational”
Then comes weeks / quarters .. sometimes years of this stupidity / irrationality. And you start to slowly lose your mind as you scream at your screen every day.
What’s going on here? As my dog’s favourite song goes:
If this has happened to you, then:
You are ignoring that you operate in a hyper-competitive market. Nonsense! You’ll say. I deal in small caps where institutional funds can’t go. Wrong. This is like a lightweight boxer saying their division isn’t filled with heavyweights so they’ll have an easier time.
You suffer from a superiority complex. The subtext behind the above thought process is: “I am a rational investor. Other participants are idiot gamblers.” There are millions of investors out there. Yes some of them are dumber than others. No, it doesn’t automatically mean that you are the sole voice of reason.
You are misunderstanding your job. There is a whole lot of mysticism and vague self-help quotes that surround the process of investing. Simply put: a big part of your job is to predict the future stock price. Your level of conviction should translate to one thing: the stock price going up. If you had high conviction in something, and this did not happen, it’s not Mr. Market being irrational. You were wrong.
You are misunderstanding the nature of what “mispricing” is. The popular notion of irrational Mr.Market has led to many people believing that the wrong price = market being temporarily irrational. This is incorrect. Mispricing comes from market failures. Some of them get corrected quickly, others take a long time: just ask David Einhorn. Even if you do happen to be the voice of reason within an irrational and inefficient marketplace, it doesn’t automatically mean you will generate high returns.
So - what does all of this have to do with empathy? And why is this woo-woo concept helpful in generating better returns?
When you find something that seems deeply mispriced, your primary goal should be to understand and empathize with the other side. Clearly, there are thousands / millions of others that see the same price on the screen as you do but are either not buying, or selling. What are some reasons that would make a smart and rational person act this way?
The second question you need to ask is: “How / why does this change?” What piece of news will get people to change their minds? What will make them act differently?
Many times, you won’t be able to come up with a good answer to this question. And that’s OK! But if you can’t, you must adjust your conviction level. There’s nothing wrong with owning a mispriced stock with no/unclear catalyst. The only problem is in combining this with a bet size that implies you know what’s going to happen with a high level of conviction.
Some may recognize the above process as the famous “variant perception + catalyst” approach. There is one key difference: empathy. Usually, the process is run very analytically, from the position of “Here is what Mr. Market is not getting.” Your job is not to point out why the other side is being irrational. It’s to understand where they are coming from. Doing so will lead to much better prediction accuracy and appropriate conviction level - because you’re not treating them like an idiot. You’re treating them as just another market participant.
Which is … you.
Postscript: This piece is written in a strong form in the hopes that it will elicit a stronger response. If you disagree, let me know in the comments. If you think this is too obvious, let me know in the comments. If you have other additional thoughts? Comments.