By Christopher M. Wright

NAME: Michael Mauboussin BORN: 1964 TITLE: Chief investment strategist at Legg Mason Capital Management and adjunct professor of finance at Columbia Graduate School of Business. EXPERIENCE: Mauboussin earned a bachelor's degree in government from Georgetown University and joined Credit Suisse First Boston in 1992 as an analyst. He worked up to managing director and chief U.S. investment strategist before leaving to join Legg Mason Capital Management in 2004. Mauboussin has been named to Institutional Investor's all-American research team and listed as one of Smart Money's "Most Influential People on Wall Street." He has been an adjunct professor at Columbia since 1993 where he was named one of seven "Outstanding Faculty" by BusinessWeek. He is the author of "More Than You Know: Finding Financial Wisdom in Unconventional Places" (Columbia University Press 2006) and co-author with Alfred Rappaport of "Expectations Investing: Reading Stock Prices for Better Returns" (Harvard Business School Press 2001).

What can ants, zebras and slime mold teach us about investing? "More Than You Know," as Michael Mauboussin, who is Legg Mason Capital Management's senior vice president and chief investment strategist, titled his recent book. The book, which is an updated version of Mauboussin's renowned newsletter essays written when he was at Credit Suisse First Boston, ranges far and wide to draw investment lessons from social psychology, evolutionary biology and other disciplines. Portfolio recently sat down with Mauboussin, who has appeared on The Wall Street Journal 's all-star survey, to learn how understanding big ideas from other fields can make you a better thinker and investor.

Portfolio: You view the market as an ecology that is healthiest when there is a diversity of investors. What do you mean by this?

Mauboussin: We've seen evidence where the aggregation of diverse individuals can solve problems very effectively. For example, I asked my students at Columbia Business School to guess how many jellybeans are in a jar. A simple average of the answers was within 3 percent of the correct answer, making the collective better than any single individual in the class. For the crowd wisdom to work in the stock market, you need to have diversity in the underlying agents. By and large, investors operate from diverse perspectives—different time horizons, fundamental versus technical, all sorts of people mixing together. When you have diversity, markets are efficient and stocks are priced correctly.

Portfolio: But stocks get mispriced and herding occurs. How do you square this with the wisdom of crowds?

Mauboussin: Diversity leads to efficiency and breakdowns in diversity lead to inefficiencies. Individuals periodically tend to get on the same side of the ship and it tips. Decisionmaking, whether in the board room or on the trading floor, is a highly social activity. Others' actions influence your decisions.

We see diversity breakdowns in other complex adaptive systems. An example of this in the book is the behavior of circular mills of ants. Ants almost always operate in a very diverse way to solve problems, but under specific circumstances they can follow each other around in a circle until they collapse. Likewise, people tend to correlate their behaviors. But manias and crashes are the exception, not the rule. So the crowd wisdom argument explains why markets are largely efficient, but also allows for situations where behaviors become correlated and we get substantial inefficiencies.

Portfolio: How do I know when the crowd is wise or has gone mad?

Mauboussin: We try to understand the expectations built into the price. We reverse-engineer the current stock price for a set of financial expectations that solve today's price. Then we analyze both the company and the industry to judge whether the expectations are too high or too low. We analyze how high the company can jump and look for mismatches between where the bar is set.

Portfolio: It's intriguing that you found that a disproportionate number of the best-performing mutual funds are based outside of New York.

Mauboussin: That got me in a lot of hot water before I moved to a Baltimore-based firm. The observation would be something I call the 'noise' or 'cacophony' factor. When you're in a financial center, you tend to be immersed in a lot of information flows and chatter, and a lot of that doesn't help you make good investment decisions. When you're out in the Midwest or the Southwest somewhere, and you're not in that flow every day, you have more time to think. Having too much information can be as deleterious as not having enough.

Portfolio: It's interesting that you're not just talking about generating a single number, but several expected values across different scenarios that weigh the probability of each scenario actually happening.

Mauboussin: It's important to think about the range of possible financial outcomes for a business, like what happens under different assumptions for economic growth, interest rates, etc. Then calculate a share price for each. Next, you assign probabilities to those various scenarios. Multiply each outcome by the probability and add those together to get expected value. So we create these outcomes, assign probabilities to them and that generates an expected value.

Portfolio: Where do you get the probabilities from?

Mauboussin: One way is subjective, degrees of belief guided by your experience and analysis. Another is a frequencies approach, where you look at a sample of similar occasions and see how those have unfolded. In any event, it's a constant updating process as new information comes in because information can change the outcomes, the probabilities or both.

Portfolio: When do you buy?

Mauboussin: We like to buy stocks that are below their expected values. We're looking for situations where the stock is trading near some kind of floor—net asset value, price-to-book ratio or a yield. The downside is limited and you have a lot more upside. Today, we perceive that a lot of large-cap stocks are undervalued. Buying a basket of large-cap stocks will deliver good results over the next few years.

Portfolio: Given your faith in the wisdom of the collective, are you saying that your expected value analysis will lead you to conclude that the market has priced stocks correctly in most instances?

Mauboussin: Yes, in most cases it is unlikely that a thoughtful and informed investor will have a point of view that is strongly different from that of the market.

Portfolio: How do REITs look when filtered through some of these ideas?

Mauboussin: We don't have much exposure in REITs, which is not any sort of commentary about them. We just don't have the expertise and we like to stay in our circle of competence, as Warren Buffett calls it. However, expected value applies in real estate markets as well.

There's an important distinction between the fundamentals, the economic backdrop and prospects, and the expectations of what has to happen in order to make property or REIT stocks attractive at any given price. Fundamentals and expectations should be thought of separately. Many people want to get in when the fundamentals are very good and flee when they are bad. The best decisions may be controversial at the time, but are made by people who can see when expectations are too low given the long term fundamentals, and they tend to do very well. The great investors constantly sort through fundamentals and expectations in their mind and understand when they should step in and step out.