Two reasons to buy insurance

Buy insurance for protection.

There are 2 reasons for buying insurance:

1.  To protect against loss which you are unable or unwilling to bear.

2.  The insurance company is selling you a policy that is too cheap.

Choose an insurance company with the ability to pay out, even in the most extreme situation.

How to measure investor sentiment and how you can profit from this?

Closed-end funds

Individual investors are the primary owners of these funds as opposed to institutions.

Institutions such as mutual funds don't buy shares of closed-end funds or other mutual funds because their customers don't like the idea of paying two sets of fees,.

We can postulate that individual investors would be more flighty than professional investors, such as pension funds and endowments, and thus, they would be subject to shifting moods of optimism or pessimism ("investor sentiment").

When individual investors are feeling perky, discount on closed-end funds shrink and when they get depressed or scared, the discounts get bigger.


Small companies

Individual investors are also more likely than institutional investors to own shares of small companies.

Institutions shy away from the shares of small companies because these shares do not trade enough to provide liquidity a big investor needs.



How to measure individual investor sentiment?

So, if the investor sentiment of individuals varies,  it would show up both in the discounts on closed-end funds and on the relative performance of small companies versus big companies.

That is exactly what was found.  The average discount on closed-end funds was correlated with the difference in returns between small and large company stocks; the greater the discount, the larger the difference in returns between those two types of stocks.



How to profit from this investor sentiment variability?

The strategy of buying the closed-end funds with the biggest discounts earned superior returns (a strategy also advocated by Benjamin Graham).  Burton Malkiel, author of A Random Walk Down Wall Street, has also advocated such a strategy.

Genuine News and Noises

Intrinsic value cannot be determined with precision, which makes it hard to prove that stock prices deviate from intrinsic value.


An important principle at the heart of the Efficient Market Hypothesis is the law of one price.  The law asserts that in an efficient market, the same asset cannot simultaneously sell for two different prices.  If that happened, there would be an immediate arbitrage opportunity, meaning a way to make a series of trades that are guaranteed to generate a profit at no risk.


News and Noises

The only thing that makes an investor  change his mind about an investment is genuine news.

But humans might react to something that does not qualify as news, such as seeing an ad for the company behind the investment that makes them laugh.  In other words, there are many who make decisions based on noises rather than actual news.  These are called "noise traders".  They trade on noise as if it were information.  "THERE ARE IDIOTS.  Look around."

Picking the best stocks is like picking out the prettiest faces in a beauty contest.

Keynes wrote:  "Day to day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market."

Keynes was also sceptical that professional money managers would serve the role of the "smart money" that Efficient Market Hypothesis defenders rely upon to keep markets efficient.  Rather, he thought that the pros were more likely to ride a wave of irrational exuberance than to fight it.  One reason is that it is risky to be a contrarian.  "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."



Keynes's beauty contest analogy

This is still an apt description of what money managers try to do.

Many investors call themselves "value managers," meaning they try to buy stocks that are cheap.

Others call themselves "growth managers," meaning they try to buy stocks that will grow quickly.

But of course no one is seeking to buy stocks that are expensive, or stocks of companies that will shrink.

So what are all these managers really trying to do?

They are trying to buy stocks that will go up in value - or , in other words, stocks that they think OTHER investors will LATER decide should be worth more. 

And these other investors, in turn, are making their own bets on others' FUTURE valuations.

Buying a stock that the market does not fully appreciate today is fine, as long as the rest of the market comes around to your point of view sooner than later!