CHAPTER 2Why Can Active Investment Strategies Work?

“The worst thing I can be is the same as everybody else.”

—Attributed to Arnold Schwarzenegger

The debate over active investing versus passive investing is akin to other classic conflicts, such as Philadelphia Eagles versus Dallas Cowboys or Coke versus Pepsi. In short, once our preference for one style over the other is established, it often becomes a proven fact or incontrovertible reality in our minds. Psychology research describes the notion of “confirmation bias,” in which people prefer evidence that supports their earlier conclusions, and ignore disconfirming evidence.

The following discussion is not meant to convert a passive investor into an active investor; however, we do explain why we believe some active investing approaches, given certain characteristics, might logically beat other investment strategies over a reasonably long time horizon. In other words, what drove the success of Munehisa Homma, Jesse Livermore, and Ben Graham, when all three active investors had dramatically different investment philosophies? Perhaps it is all just luck, but we believe there might have been something more.

A key theme that seems to underlie all of their approaches is the exploitation of irrational investor behaviors. But if understanding behavior were the Holy Grail, why aren't psychologists running the capital markets? Or perhaps Homma, Livermore, and Graham were just smarter than everyone else? Being smarter does not seem to ...

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