You spoke about common behavioural mistakes that investors make — the base rate problem, the problem of over confidence, the idea of regression to mean or oversimplifying multiples. Can you elaborate on these?
The classic way to look at problems is to gather lots of information and combine it with one’s experience and input, and project them into the future. That’s how analysts, typically, look at a stock — they gather information, build a model and then forecast. The outside view, that is, the application of base rate, asks a much more simple question as to what happened when other companies were in similar situations before. It allows you to understand a company’s performance in a historical context. As often is the case, especially for growth companies, investors ignore the base rate and focus too much on their own information and experience. And in many cases, they tend to be too optimistic in projecting the growth rate while valuing these companies.
It ties back to one of the finer findings in finance, that is, growth stocks typically underperform value stocks. One way to think about that is, growth stocks have high expectations and value stocks have low expectations because, in both extremes, there is not enough weight placed on base rates of performance. Hence, base rates are really an important way to ground an investor’s thinking about corporate performance.
You have to understand base rates in