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Who's in the Video
Michael Mauboussin is the chief investment strategist at Legg Mason Capital Management. Before joining LMCM in 2004, he was a managing director and chief U.S. investment strategist at Credit Suisse.[…]

We like to follow a bullish or bearish trend. But the best investors sell when everyone’s buying, and buy when everyone’s selling.

Question: Why are we wired to make bad investing decisions? 

Michaelrn Mauboussin: The wisdom of crowds tends to work when you have you rnhave three conditions in place. The first is diversity, so all of us arern acting and thinking and operating in different ways. A properly rnfunctioning aggregation mechanism would be the second; so ways to bring rnour information and our varied views together. And then, finally, rnproperly functioning incentives, which are rewards for being right and rnpenalties for being wrong and of course, they can be monetary, but they rndon’t have to be. 

So when those things are happening, you tend rnto get very good results from groups and markets themselves tend to be rnpretty well functioning and "normal." Now the flipside is what happens rnwhen one or more of those conditions are violated and by far the most rnlikely to be violated is diversity. So rather than each of us thinking rnindependently, with our own points of view, we start to coordinate our rnbehaviors. And this is a very, very natural human reaction. We like to rnbe part of the group and we like to go with what is working and this, I rnthink, is ultimately the bane of most people when they invest, which is rnwhen things are going really well, all the fibers in your body says "I rnwant to be a part of that group and I want to be making money along withrn that group." And inversely, when things are going badly, you become rnvery fearful and you want to avoid it. It’s almost a notion of disgust, rnyou almost push it away when. in reality, we know from a lot of rnexperience that you want to be selling when everyone’s buying and buyingrn when everyone’s selling. 

So it's very... our innate sort of rnmotivations are almost counter to what makes you a successful investor rnand I guess the last comment I’d make on that is you find that many of rnthe great investors, very successful investors, are those that really, rnin some ways, can be an emotional check. They don’t tend to be swayed byrn the views of others around them; they tend to be very independent, rnwhich, you know, I think is a fairly unique trait that can be developed rnto some degree, but think it’s a very unique trait for most great rninvestors. 

Question: Is it best to take a contrarian rnview of the market? 

Michael Mauboussin: I think it’s arn little bit deeper than that. There’s a really successful investor in rnBoston named Seth Klarman, he runs something called the Baupost Group rnand they’ve done really great over a long period of time and he’s got a rnline which I just love which is "Successful investing is the marriage ofrn a calculator and a contrarian streak." So maybe start with a contrarianrn streak. It really is important to be a contrarian, sort of do what rneveryone else is not doing. That said, that’s not enough, right, becausern sometimes being a contrarian for the sake of being a contrarian is a rnreally bad idea. In other words, if the movie house is on fire, by all rnmeans, do run out the door, right, don’t run in. So sometimes the crowd rnis correct. 

The calculator part is the second one, which is if rnthe group is off on one side or the other of the ship, tilting the ship,rn then you have to apply a calculator, which is determining whether the rnexpectations built into the asset price, let’s say a stock to make it rnconcrete, misrepresents the fundamental prospects for that company. So rnare the expectations and fundamentals mispriced relative to one another?rn And that does require some analytical work.  

The best metaphor rnfor the expectations of fundamental really is the racetrack; horse rnracing, so you know there are two different things. One is the odds and rnthe tote board, which dictate the probability of a horse winning or rncoming in at some place, and then the actual performance of the horse. 

Knowingrn which horse is going to win every race doesn’t make you money because, rnof course, it’s already reflected in the price. The key is to find rnmis-pricings between the tote board and the performance of the horse andrn it’s a very similar thing. So it’s the contrarian streak plus the rncalculator, I think, is the one/two combination. 
Recorded on May 14, 2010
Interviewed by Jessica Liebman