From Michael Mauboussin at Blue Mountain Capital Management:
How does an investor effectively take advantage of behavioural inefficiencies?
Be mindful of sentiment and overextrapolation. Using Graham’s metaphor, Mr Market is generally reasonable and price is roughly equivalent to value. But Mr Market is prone to extremes. When sentiment is uniformly positive or negative, be prepared to visit the opposite side of the argument. But being a contrarian for the sake of being a contrarian is a bad idea, and the consensus can be correct.
Rely on valuation. When markets go to extremes, valuations tend to follow. The crucial question is, "What expectations for future financial results are implied by the current price?" When sentiment shifts are excessive, expectations become unduly high or low. Figure out what you have to believe to justify the prevailing price, and compare that to plausible scenarios.
Lean on facts. When an asset price is under the spell of extreme sentiment, make an effort to separate facts from opinions.
Timing. Behavioural inefficiencies can have different cycles. For example, momentum tends to reverse over a relatively short period of time of less than a year. Large bubbles can take years to burst. Taking advantage of behavioural inefficiencies can take more time than investors perceive they can afford.
Benjamin Graham offered what might be the best advice. He said, "Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it — even though others may hesitate or differ. (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.)"
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