We have classified market participants into five types. In this post, we describe the deluded investors in more detail. As explained before, they are foolish market participants who are uninformed but transact in financial markets with the delusion that they are informed. So deluded participants would trade actively in an attempt to outperform when a security is mispriced according to their analysis. They are, however, wrong in believing that they know the fair value of the security.

For example, you want to invest in the short-term automobile insurer Progressive Corporation listed on the NYSE. The following might be relevant information for determining the company’s fundamental value:

  • Hailstorms are bad for Progressive Corporation’s earnings, see here.
  • A scientific paper, published in the March 2015 issue of Nature Geoscience, shows that La Niña boosts the odds of tornadoes and hailstorms in the USA while El Niño reduces the odds.
  • “The Climate Prediction Center delivers real-time products and information that predict and describe climate variations on time scales from weeks to years thereby promoting effective management of climate risk and a climate-resilient society.”

Deluded investors in Progressive Corporation’s securities might be unaware of some of the above pieces of information. Alternatively, they might not have the ability to process the above information correctly.

There are professional investors who use weather forecasts in their analyses, such as the hedge fund business Cumulus. They are the informed participants when it comes to securities whose fair values are weather dependent. Those who attempt to value these securities, without this knowledge, are deluded.

As explained above, investors can be deluded in two ways. Firstly, they might incorrectly believe that they have all the relevant public information for their analysis.  Secondly, they might possess all the necessary information but are unaware that they do not have the skill or even the time for processing it. Either way, their calculation of the security’s fundamental value is flawed.

Whether it is at all possible to collect all the public information on a security and whether it is possible to calculate its fundamental value, assuming you have access to all required information, are debatable. These topics will be discussed in future posts.

Now, why then would there be deluded traders at all if the fundamental value of a security is tractable? As in the example above, this could simply be due to a lack of ability, experience or training, without realising it. An alternative explanation would be that psychological factors, also called behavioural biases, interfere with the ability of deluded investors to analyse a security. We shall discuss this further in a future post.

Note that investors would never be able to validate, even after the fact, whether they were informed or deluded when they transacted. This is so, because, a security’s fundamental value is continuously changing as new information arrives.

However, to outperform the market, participants should be informed more often than being deluded. Hence a successful investor is typically better in establishing whether he is an informed, rather than a deluded, counterparty to a transaction.  There might be securities where it is just too difficult to become an informed investor. With such securities, it would be better to be a passive holder/investor. Charlie Munger puts these securities onto the “too hard” pile.

There is one final question which we shall address in a future post: Would deluded market participants not discover, after underperforming the market for some time, that they are uninformed and as a result convert to become rational uninformed participants?