Exploiting the Anomalies

Less Guts, More Gain

Given that it’s well established that people are behaviourally biased and that market prices are impacted by these biases you might think that it ought to be possible to profitably trade on the underlying anomalies that these generate. However, by and large, it seems that this doesn’t happen, either because the anomaly vanishes as soon as it becomes widely known or because it’s not actually possible to trade on the thing for one technical reason or another.

If this is the case then behavioral finance ends up being an interesting research area but one that’s difficult, at least for ordinary mortals, to exploit other than through the tried and trusted means of learning to ignore the instincts of our guts. Still, as you might expect there are people out there seriously looking at whether there are profitable trading strategies that might be exploited. The slightly surprising answer seems to be that there are.

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Value in Mean Reversion?

Many shall be restored that are now fallen; and many shall fall that are now in honour (Horace, Ars Poetica)

From Horace to Graham and Doddsville

The quote above is now a couple of thousand years old but was used by Ben Graham and David Dodds in their seminal book on value investing, Security Analysis, a term invented by the book's title. At root it’s a simple plea for understanding that current market conditions, no matter how placid or tempestuous, will pass. The job of the conscientious investor is, at worst, to ignore the short-term forecasts or, at best, to take advantage of them.

Some psychological quirk means that a small subset of humanity latches onto this concept instantaneously and holds to it, like an investing life preserver, through thick and thin. The rest of us either learn the slow, hard and painful way or, more likely, continue to be storm-tossed. Occasionally someone gets washed up on a tropical paradise and is accounted a genius but mostly we drown, quietly, where no one can see us waving.

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