Connecting Valuation with Entrance Timing

My Investment Management and Trading Strategies class has moved into the trading strategies portion of the curriculum, and we have been talking a lot about the tradeoff between execution costs and opportunity costs. This discussion has helped flesh out some of the classic arbitrage examples behavioral investors like to point out, as we quantify the frictions in the efficient market system which can give rise to these mispricings. While the big mispricings are interesting to study, I think the magic lies in all of the small mispricings.

It struck me in class that the biggest weakness of any valuation activity is the time period of applicability. On one had you have the trade-off every science deals with. The more exact the measurement, the more time the measurement takes, and thus the staler it gets. But finance struggles with another application hurdle; even if you can solve for the 'true' price of an asset instantaneously, you have no idea when the market price will move to that value or if in fact it ever will. You are subject to two independent risks, the market can stay wrong or get 'wronger' (move against you), or your true price estimate becomes untrue as information enters the market about the asset and the valuation changes.

You might say, sure but we do know that the market moves to the true price in the long run. I'd agree, but that true price is always changing. If the market price of X is higher than you think it should be, you might short X. Let’s say X is trading at 15, and you think it's worth 12. Your expectation is that X will drop from 15 to 12. You might even hedge your short with a long on the S&P to protect from systematic changes in the stock’s value, and only short the 'firm specific' valuation of the stock. What is to say the following doesn't happen: positive idiosyncratic information enters the market, and the market and true price rise to 17. The S&P doesn't change (by much) because only the stock reacted to the firm specific information, your short is a loss of $2, and your hedge didn't protect you. Even with absolute knowledge about the true price, you can lose money.

I think this is why some very successful asset managers seem to know very little about valuation, or sometimes even seem to care about it. Successful investment seems to be much more about the interaction between the market price and the true price over time. Decent money managers can get by with only knowing how one of the sides works. Traders only focus how the market price changes over time, 'deep value' investors focus intently on the derivation of the true price and somewhat haphazardly jump in when they feel the spread between the market price and the true price is big enough to warrant the risk of jumping in. A true master of investments should know both.

I'm trying to develop a checklist for investments that will focus my efforts on balancing these two fields. It will need to balance both fundamental and behavioral considerations. As luck would have it some much brighter minds are working on accomplishing exactly that!