A lot of investing mistakes happen unwittingly. These matter because they can have a massive effect on your long-term returns.

Michael Mauboussin previously discussed the biggest mistakes investors make as well as how to overcome them.

Let’s look at Michael’s ideas, which cover:

1. Failure to use base rates

2. Failure to understand regression to the mean

3. Overconfidence

4. Relying too much on multiples

5. Failure to compare effectively

6. Techniques to overcome biases

7. Other investor’s mistakes that you can benefit from

Mistake 1: Failure to use base rates

When looking at an investment, there are two points of view. The inside view and the outside view. The inside view involves gathering information on the company, using experience to build a model and then projecting that performance into the future.

The outside view is different. Here one looks at what others have done in similar situations and whether it is likely to happen in future.

For example when Amazon had $100 billion in revenue, analysts were forecasting that it could continue to grow at 15% p.a for the next 10 years. No company at that size had ever done that before. The inside view might have indicated it was possible, but the outside view indicated that it was improbable.

The benefit of looking at base rates is that it gives you something to ground your expectations on, rather than forecasting in isolation.

Mistake 2: Failure to understand regression to the mean

Regression to the mean is about things far above or below the average slowly moving toward the average. For example companies that earn very high or very low returns will tend to gravitate toward the average return over time.

Mauboussin observes that some activities are all luck-based (e.g. gambling) while other activities are all skill-based (e.g. chess). Luck-based outcomes revert to the mean rapidly while skill-based outcomes do not.

When looking at business, gross profits or operating margins tend to be more skill-based, whereas sales growth and earnings growth are closer to luck-based. Analysts can fail to recognise this when forecasting.

Mistake 3: Overconfidence

In the context of investing, overconfidence shows itself in a person thinking that he/she understands the future better than they really do. The result is that investors model outcomes too narrowly. This leads to unpleasant surprises in future.

Mistake 4: Relying too much on multiples

Multiples (such as the P/E ratio) are not actually valuation methods. These are shorthand techniques for valuation. As a result, they have blind spots.

For instance if a company earns a return on capital equal to its cost of capital, it is performing averagely and does not necessarily deserve a high valuation.

If a company’s return on capital is higher than its cost of capital, then it is creating value and deserves a high valuation.

If a company’s return on capital is lower that its cost of capital, then it is destroying value and deserves a low valuation.

None of this is reflected in multiples. The point it is that investors can use multiples but must understand their limitations as valuation tools.

Mistake 5: Failure to compare effectively

People tend to compare by analogy. We say “this” is like “that”. There are two comparison mistakes - breadth and depth.

With a breadth mistake people have limited memory and sometimes do not come up with the appropriate analogy.

With a depth mistake people find the analogy but the comparison is superficial.

Failure to compare effectively comes up in investing when analysts look for comparable companies and then use this data to make their case.

One way to combat this problem it to use similarity scores, where you look at all types of companies that have features common to your focal company. You do not limit yourself to companies only in your industry. This gives you a more robust way to think about comparison.

Techniques to overcome biases

It is important to build your processes to help you overcome biases, rather than just being aware of biases. One way that investors can overcome biases such as overconfidence is to bring in colleagues and ask them to critique your work and point out what you have missed.

This can be done with methods such as red-team, blue-team. The red-team plays devil’s advocate while the blue-team supports your investment case.

Other investor’s mistakes that you can benefit from

Professional investors can often sell for non-fundamental reasons. These could include things like leverage. If a professional investor has borrowed money and has to pay it back, this might turn them into a forced seller. A private investor can pick up bargain purchases at these times.

Sometimes a company has a spin-off and professional investors will sell the spin-off company because it does not fit their mandate. This can cause mispricing and therefore investment opportunities.

Crowds are wise when they:

• have diverse opinions,

• have a properly functioning aggregation mechanism (such as the stock market), and

• have proper incentives.

These factors are normally found in stock markets, which is why a large number of stocks are properly priced. However, when one of these mechanism’s break down, mispricing can occur.

Diversity breakdowns happen often. This occurs when all the participants start to think in the same way. For instance, in the past decade money was close to free in the USA. As a result markets went upward. No one thought that it was possible to lose money. The property market was particularly hot, with many people buying property to rent. That situation has changed and some investors are now stuck with properties that don’t earn enough to pay the bills. Inevitably, there will be opportunities for savvy investors in these markets.

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