The stock market is a very emotional place. Why? Because it is made up of humans beings. Fear and greed are felt and then played out, which is why you’ll see irrational bull and bear markets. Warren Buffett’s mentor, Benjamin Graham, tried to explain this phenomenon with a fictional character he called Mr. Market.
Graham used the Mr. Market metaphor to not only explain why the stock market behaves emotionally, but to discuss how investors can capitalize on these exact characteristics.
He tells the story to show exactly how stocks can become mis-priced, trading at prices that may be cheap one day and expensive the next. Investors who understand this can buy the stocks that are underpriced and sometimes sell stocks that become overpriced, to profit from the market’s madness.
Who or What is Mr. Market?
Graham described a character he called Mr. Market in his bestselling investing book, The Intelligent Investor. You are the owner of a very successful business. Say you have a man who has bipolar disorder. His name is Mr. Market.
Now because Mr. Market is bipolar, he gets really extreme mood swings. Everyday he comes up to you and offers to buy your business at a price. Some days he’ll be in a very good mood and offer you a high price for your business. Others he’ll be very depressed and offer such a low and unfair price.
All along the way, you still own a successful business. That fact doesn’t change from day to day, but the prices that Mr. Market quotes does.
You wouldn’t sell your successful business to Mr. Market at a low price just because he is in a bad mood. Maybe you would decide to sell if the price is high enough, because you understand what your business is worth and that you’re getting a good deal.
This is exactly what happens in the stock market with investors and traders. Stocks represent ownership pieces of a public corporation. A business. Wall Street quotes prices on these businesses every single day, and the price quoted can vary wildly depending on the market’s “mood”.
You can see evidence of this exactly by looking at a 1 year chart of a stock. Many financial websites quote a 52-week high and 52-week low, and the difference between the 2 figures can be quite high. Yet in a one year period, it’s very unlikely that the actual value of a business is changing that rapidly.
The business world moves much slower than Wall Street, and that’s just the nature of the market. This creates pricing discrepancies to a business’s intrinsic value.
Why does Mr. Market Behave This Way?
You might be skeptical about this metaphor by Ben Graham. After all, the market is a very large place made up of some of the smartest people on the planet. How could it make such bad pricing mistakes all the time?
Well let’s consider how the stock market is comprised. Let’s go a little deeper. Picture your nearest car dealership. How do they make money? Forget making money through financing, expensive add ons and repairs for a second.. let’s just look at the basics.
A car dealer will buy let’s say, 10 cars at $5,000 each from a manufacturer. He will then sell each car at $17,000. Once he sells 10 cars, he has $120,000 ($12,000 profit times 10 cars). Say he spent $20,000 on marketing and employees. Now he has $100,000 and he can buy 20 cars and keep growing the business.
Now, most of us don’t have $50,000 lying around to buy 10 cars, or $20,000 to keep the business running, or time to supervise and hire employees. Too bad huh? One guy gets rich and the rest of us stay poor?
Well consider this. Say that this car dealer has 6 partners in the business. They all pitched in money at the beginning to get it all going. One partner has seen the business grow and wants to cash out. So he puts his ownership stake for sale for anyone to buy.
Again we may think that we need $100,000s to buy out the partner, because the business has grown quite large.
But consider one last thing. Say that the partner has a salesman who us going around town selling pieces of this ownership. So whether you want to buy $100 or $1,000 of the business, you can split the ownership with other people in your town.
Now we’ve changed the dynamic a bit. Anyone with a little money and the desire to see it grow can make money along with the dealer as his business booms. Instead of one man getting rich, a whole town could be getting richer together. Which could create more car sales and could make the town richer, creating a positive feedback loop and prosperity that continues to compound for everyone involved.
This is basically what the stock market is.
The “salesman” of the partner’s ownership is simply stock market brokers. And instead of one partner wanting to cash out, there are hundreds, thousands, or millions of people constantly wanting to buy or sell ownership stakes.
If you invest in a business and it grows over time, you’ll have more people wanting a piece of it and willing to pay more. That becomes the Mr. Market effect. When you have many people participating in a market like this, the decisions made can often influence other people’s decisions.
How Evolutionary Psychology Can Explain Investment Behavior
Whether you believe in evolutionary psychology as a pseudo science or not, it’s not difficult to observe that humans are natural “pack animals”.
From an evolutionary perspective, in the days when humans had to fight against nature for survival, it was the humans who teamed up together as a tribe who survived against the bitter cold, the dangerous animals, and the necessity to hunt and gather enough food to survive.
Being outcast against the tribe became a literal life and death situation. Without advanced technology, it would be very difficult to fight off a bear, find a cure against a venomous bite, and do all of the other things needed to survive– like build enough shelter while also hunting and gathering enough food for when such resources became scarce.
While in today’s world humans don’t have to fight the same battle, there’s an intense ingrained fear about being isolated from the pack.
Many people report having an intense fear of public speaking. That flight-or-fight response can be attributed to the fact that at that moment, you are outcast from the rest of the group. All eyes are on you while the crowd watches. One mis-step or poor choice of words can isolate you from them even further.
Another example of this, while terrible to think about and bring up, is the violent mass killers that keep springing up. Many of these people have deep mental issues stemming from isolation and rejection from the tribe.
Human beings are social creatures. We crave relationship and connection with others, and when we don’t have it, it can be destructive in our lives.
So it’s this innate fear of being isolated, and the default wiring to be part of the crowd, that makes the people participating in the stock market to act with a “herd mentality”.
It’s not too hard to connect the dots. When you buy a stock today and the price goes up tomorrow, you feel validated. Another investor or group of investors have confirmed your idea that this company is worth owning at its current price. An investor feels good from this, and wants to replicate that again and again.
Picture many investors experiencing these emotions in this way, and you get investors piling into the same types of stocks and all feeling good together.
Then you combine this with economic realities. During times of loose credit and low interest rates, the economy becomes awash in lots of cash. This cash is used to create jobs and buy assets, sending asset prices up (stocks are an asset). As people become employed, they have more cash to spend– which pushes profits higher at many businesses and continues the cycle, like in the car dealership metaphor above.
The collective herd mentality creates a feedback loop that eventually plays out in behaviors like in the Mr. Market story by Benjamin Graham.
Fund Managers and Career Risk
According to BlackRock in a 2017 report, 17.5% of the global stock market was made up of mutual funds, ETFs, and investors who track an index, and 25.6% was made up of actively managed funds like hedge funds and mutual funds.
These types of funds play a role in how the market moves and behaves, and because of the way they are constructed, they add additional factors besides basic human psychology.
My co-host Dave and I discussed some of the ways the financial industry actively hurts individual investors through conflicts on interest and other things, and fund manager career risk is just another one of those types of examples.
In the mutual fund and hedge fund industry, managers are tracked on their performance with a very hot spotlight. Because funds charge investors based on a percentage of total assets, it often means that funds make more money by attracting new customers rather than actually making great long term returns.
You better believe that these funds have observed the average customer and know that they tend to look for two things when it comes to picking a new fund: what’s been the recent performance and what stocks/ sectors is the fund invested in now.
The stocks that have been doing the best recently in the stock market tend to be the stocks that new investors want to have exposure to. Which means, like discussed earlier in this post, the “hot” stocks continue to fly higher because those are the ones that new investors want to be in. At that point price doesn’t matter, what matters is that the investors are holding the stocks going up the most at the time.
Many fund managers receive bonuses based on the management fees they can produce, and so if you can attract the most customers by owning all the “hot” stocks, you can receive the highest bonus regardless of how much you lose in a bear market.
Which brings me to the next part of career risk.
A manager who lags the overall market will be on the receiving end of a lot of criticism and will have trouble attracting new clients. A manager who loses money for his clients when the rest of the market is losing money won’t receive the same heat, simply because everybody else is all in the same boat.
It goes back to that herd mentality, and as a fund manager who wants to keep his job, you’re better served sticking with the crowd. Standing out like a sore thumb could eventually lead to better results over the long term, but in a short-term focused industry like this it could mean losing your job instead.
The system is simply set-up the way it is, and this is why Mr. Market is so emotional. All the forces combine and compound. This again creates mis-priced stocks.
What Investors Can Do About It
Hopefully you understand that there’s an ingrained aspect of the stock market that’s been observed repeatedly throughout history. Hopefully you understand a bit why the Mr. Market phenomenon can manifest itself so easily.
The next thing for you to do is to read this situation and react from it.
You see, you can absolutely start putting your dollars to work today. You can start with as little as enough to buy one share + a $4.95 transaction cost. And you can own part of a business that is working hard to grow, in one that can be just like the dealership example above.
The more money you can save and invest, the farther your dollar goes and the more you are leveraging other people’s work to create a profit for yourself.
Once you’ve discovered this, there’s really only one thing to determine. You’ll want to make sure that you are buying businesses that are growing and not sinking.
You definitely don’t want to buy into a car dealership that is buying cars for $5,000 but spending $150,000 to run the business when only selling the cars for $17,000… because you need to sell a ton more cars in a shorter amount of time. The problem there is that you’d never know how much the owner spends to run the business unless you asked him.
Well in the stock market, businesses are required to post this information publicly. So if you can find someone who can help you decipher this information, you’re well on your way to making investments in good businesses rather than bad ones.
Lucky for you, I’ve written several guides on this blog to help you do just that. If you’re a beginner and know nothing about basic financial ratios like earnings, sales, and assets, you’ll want to start on my 7 Steps to Understanding the Stock Market guide.
If you understand things like the P/E and P/B ratio and now want to go deeper into the financial statements, I have a guide that teaches you How to Read a Company’s Annual Report (10-k). Embedded in that guide are several mini-series posts on the Balance Sheet, Income Statement and Cash Flow Statement.
Finally, if you want to learn about how I personally tie all of that together to pick stocks that are undervalued because of Mr. Market, you can read about how I use the Value Trap Indicator to buy stocks trading at a discount to their intrinsic value.
Regardless of where you are today, you now know about a key component of value investing (link to another guide there)– Mr. Market and his manic swings.
Understanding that is key. It’s how legendary investors like Warren Buffett and Benjamin Graham himself have used the market to create wealth, by looking for great businesses trading cheaply and not getting tossed by the wild swings of the stock market.