One of the most important lessons from behavioural finance is that the market can stay irrational longer than you can stay solvent. Everyday investors can apply a basic test when they make an investment by asking themselves ‘does the price I’m paying for this asset seem reasonable?’ If you are buying it in the manner than many are buying Bitcoin, i.e. just because everyone else is, then you’re probably doomed to fail. The herd can seem right for long periods of time, but when they are wrong its often in a big way.
How we stay ahead
We use behavioural finance to assist our decision-making process by trying to invest before the herd has arrived and then in some ways relying on the herd to turn up at some point and hopefully drive the share price to fair value. Once this has occurred we look to exit. In addition, once we have established a holding we may look to add to this, once a company has price momentum. I've seen stocks go from PEs of 10 to 40 just because they are popular.
Anchoring in action
A recent example in one of our holdings would be EML (E-merchants). For the majority of the year, the market anchored to the first half of FY17 where some growth had been deferred to FY18 & FY19 (the key being deferred not lost). We were able to take advantage of the markets inability to think beyond six months and made this our largest position. The market “anchored” itself to the short-term result despite the longer-term picture for the company continuing to improve. EML has since risen over 40% from its mid-year lows. Having the ability to think beyond the immediate future is a big advantage to investors who have the patience invest for longer time periods.