Thread: Making Money When the Market Is Mistaken

No one ever went broke underestimating people's intelligence, H. L. Mencken observed. Among managers of a group of mutual funds offered by J. P. Morgan, a school of thought holds that there is good money to be made underestimating people's capacity to act rationally.

The funds are run according to principles of behavioral finance, the logical bedrock of which is that people are illogical, yet predictable. Adherents of this approach do not ignore the nuts and bolts of business - profits, sales, cash flow and so forth. But they contend that investors consistently err in evaluating such information, and that astute portfolio managers can profit from the ways that others make mistakes.

"Traditional finance theory tells us markets are efficient and rational," said Silvio Tarca, one of the managers of the Morgan funds. "Behavioral finance tells us that human psychology affects investment decisions. Irrational behavior gives rise to market inefficiencies, and our investment process tries to capitalize on those inefficiencies."

The five Morgan portfolios sold under the Intrepid brand all outperformed the Standard & Poor's 500-stock index over the 12 months through March. The flagship Intrepid America, for instance, gained 11.1 percent in the 12 months through March, compared with a 6.7 percent gain for the Standard & Poor's 500-stock index. Intrepid Contrarian gained 8.1 percent in that period.

Contrarian, America and two other Intrepid funds, Value and Growth, were introduced two years ago. The fifth in the series, Intrepid European, is nearly five years old. Through their life spans, all have handily beaten the S.& P. 500.

But there can be a gap between theory and practice, he cautioned, and he said the Morgan funds needed a longer track record before their managers' ability could be gauged accurately. "You really can't judge these on a short horizon," he said.

Behavioral finance theory has gained currency among academics and economists as an alternative to the efficient-market theory, the belief that investors are rational and that the price of an asset is fair and accurate and reflects all available information about it.

"Essentially we use a behavioral screen, then spend a lot of time looking at fundamentals," Mr. Potter said. "We're taking stocks apart and looking at them more than technical analysts do."