The stock market is a very emotional place.
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 it.
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 low or sell high, 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. Other days 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?
Whether you believe in evolutionary psychology as a pseudoscience or not, it’s easy to see that humans are natural “pack animals.”
From an evolutionary perspective, it was the humans who teamed up together as a tribe who survived. Together, they fought the bitter cold and dangerous animals. They found ways to hunt and gather enough food to survive.
Being outcast against the tribe became a literal life and death situation.
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.
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 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. That’s how you get investors piling into the same types of stocks and all feeling good together.
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
A significant portion of the global stock market today is still made up of actively managed mutual funds, ETFs, and hedge funds.
These types of funds play a role in how the market moves and behaves. 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. Among those are conflicts of interest and career risk.
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. They know what average investors tend to look for when it comes to picking a new fund: what the recent performance has been and what stocks/sectors the fund is 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.
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. 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.
It starts by knowing how to estimate a stock’s intrinsic value using a Discounted Cash Flow (DCF) Valuation Model.
This is, by far, the best way that we have found to buck the opinion of the crowd and evaluate the true likelihood of how cheap or expensive a stock really is.
Regardless of where you are today, you now know about a key component of value investing (link to our Value Investing 101 Guide is here)– 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. Investing in great businesses, buying them at a reasonable price, and not getting tossed by the wild swings of the stock market.