Michael Mauboussin
Senior Vice President, Chief Investment Strategist, Legg Mason Capital Management

"Thought Leader Forum Introduction"

Once again, welcome to the Thought Leader Forum. I would like to take a few minutes to set up what we'll be talking about over the next few hours. We're trying to achieve three important goals. The overarching goal for us is to share some people and their ideas that have been influential in our investment process. Second, we want to encourage a free flow of interaction. We've set aside time for Q&A with each speaker, so as these speakers are talking, jot down your notes and then feel free to ask any questions. Finally, we want everyone to have an enjoyable experience. There will be a lot of ideas thrown at you, and we want them to be fun and stimulating and provocative.

One of the things we'll be talking about is process. If you have a quality process, then one of its features is quality decision making. So I'm going to give you a little test here about decision making, and it will take about 30 seconds.

Question number one: A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost? Next question: If it takes five machines five minutes to make five widgets, how long would it take 100 machines to make 100 widgets? The third and final question goes like this: In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?

Here are the answers. The answer to the first question is five cents. If you're normal, you may have written down 10 cents. The answer to the second question is five minutes. The answer to the third question is 47 days. It turns out that the answers to those questions correlate to SAT math scores.

I'd like to mention three more things with regard to the brain and behavior. The first has to do with sources of competitive advantage. The second theme is how economics, psychology and neuroscience are converging. The third theme has to do with collective vs. individual behavior.

In capital markets, the first source of competitive advantage is informational-whether you have better information than the competition. But informational advantage is very difficult to come by, and there are mandates that restrict that kind of behavior. The second type of advantage is analytical, where you take the same information everyone else has but you analyze it better. You might weigh it differently, for example, and this type of competitive advantage is one that we spend a great deal of time on. The third type is behavioral, which has an individual and a collective component. Sometimes markets behave in ways that create opportunities for investors. Our argument would be that most mispricings are due to behavioral factors.

What kinds of things might we do to adapt to behavioral factors? First, we screen for diversity breakdowns. These are situations where there are psychological displacements. Internally we keep investment journals to make sure that our own decision making is quantified and documented. We think a lot about scenarios and how they're calibrated. In every instance we consider expectations.

I also would like to make a point about the convergence of disciplines. I can start by looking at economics and psychology. In economics, agent rationality is implicit. But the field of psychology knows that our minds use lots of shortcuts that lead to biases. In economics, the model often leads to some optimality. You have to find an optimal solution given a set of circumstances. We know from the world of psychology that we use different stimuli differently. Economics is also very prescriptive in that it tells you how you should behave given a situation. The world of psychology tells us that how we make comparisons strongly influences our decision making.

What's exciting is the convergence of these three disciplines. Economics describes how we should behave. Psychology describes how we do behave. And neuroscience shows what's going on when we behave.

The last point I want to make has to do with collective vs. individual decision making. There has been a lot of enthusiasm for behavioral finance that's well-placed, but most of the emphasis has been on individual decision making. There are some widely known biases such as overconfidence, loss aversion, framing effects and confidence bias. However, the interesting question is not so much what we do wrong as individuals but how we act as groups. Two people can be overconfident, for example. One is an overconfident buyer and the other a seller, and they can both cancel one another out. The question is how we get inefficiencies in markets through group behavior. We need to think about social psychology and how it influences or interacts with markets.

The comments, opinions and any forward predictions presented about any particular security, the economy and "the market" are based on the analysis of the speaker. These are not necessarily the opinion of, and should not be construed as a recommendation on the part of Legg Mason Capital Management or any of its affiliates.