Larry’s Note: There’s a well-documented quirk of human psychology called the “longshot bias.” People love exciting outcomes. They pile money into the low-probability, high-payout side of a trade.
Meanwhile, the boring, high-probability outcome sits there, underpriced. That’s what I look for. I identify trades where the crowd has mispriced the likely outcome. And I take the other side.
Last week, I unveiled my new trading advisory, Prediction Profits. We’re hunting for these kinds of opportunities within the prediction markets, which are rapidly gaining popularity.
The replay of last week’s event won’t stay up much longer. If you want to learn more about my strategy… and how my team and I used it to make 63 winners in just 16 days… Watch the replay here now.
One of the biggest misconceptions in investing is that markets are always efficient. In other words, every stock, bond, currency, and commodity continuously reflects all available information.
But that’s simply not reality. If that were true, prices would remain close to fair value, and trading opportunities would be scarce.
Markets aren’t driven by rational investors calculating fair value. They’re influenced by the full gamut of human emotions. As a result, markets tend to overshoot.
They overshoot on the downside when investors become too fearful. They overshoot on the upside when optimism turns into euphoria. In both cases, prices can move well beyond what the fundamentals alone could justify.
It’s one reason I’ve always appreciated mean-reversion trading. The more stocks overshoot, the bigger the potential opportunity when they eventually snap back the other way.
The flaw in the efficient market hypothesis is that it assumes investors process information rationally. But people don’t just react to information; they also react to what others are doing.
For example, when a stock starts shooting higher, many investors see other people making money and quickly jump aboard. Some don’t look at the stock’s fundamentals at all.
The excitement starts feeding on itself. Analysts become more bullish, revising their price targets higher. Then the media hype up the story, causing others to pile into the stock. Before long, the stock price bears no resemblance to any fundamentals. Buying momentum is driving prices.
What’s more, many of today’s algorithmic trading systems reinforce the move. As momentum builds, algos continue buying, pushing prices even further away from fair value.
That can seriously distort stocks to the upside – much like we’ve seen with the AI trade.
The same thing happens during market sell-offs. Bad news attracts further bad news. Fear feeds on itself as investors rush to the exits, panic selling. Soon, prices fall well below what the underlying fundamentals justify.
I saw this during the dot-com bubble. I saw it during the subprime financial crisis. And we saw it again during the COVID crash.
Investors become so convinced that the current trend will continue indefinitely that they lose sight of rationality. And that’s when I put my strategy to work.
One of the key principles behind my mean-reversion strategy is that extremes don’t last forever.
That said, it doesn’t mean that every overpriced stock should be sold, nor that every beaten-down stock should be bought. Markets can remain stretched longer than investors expect.
The goal isn’t to fight against the prevailing trend. Instead, it’s to recognize when sentiment and expectations have become overstretched in one direction… and reality is catching up with the market.
Buyers become exhausted or start taking profits. Or short sellers come into the market looking to capture a reversal lower.
Alternatively, all the bears will eventually have sold out of the stock, and investors will start being tempted by bargain prices.
In other words, the pendulum starts swinging back the other way.
Prices eventually move closer to fair value as investors get more realistic and emotions subside. That’s the essence of mean reversion. We recognize when prices have become disconnected from reality and position ourselves for the eventual return to sanity.
And after more than four decades of trading, I’ve found that some of the most lucrative trades emerge when the crowd becomes convinced that the current trend will never end.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
