This imaginary person out there — Mr. Market — is kind of a drunken psycho. Some days he gets very enthused and some days he gets very depressed. – Warren Buffett
I like the way Warren Buffett simplifies Mr. Market. On any given day, Mr. Market can quote great prices or terrible prices. You can get caught up in his manic depressive behavior or you can ignore it. You can see the market as a tool to use or it can be a tool that uses you. It’s your choice.
Ever since Ben Graham offered up the first iteration of the Parable of Mr. Market, others have stepped up with their own versions. Charley Ellis has a more descriptive version I also like:
Emotionally unstable, Mr. Market veers from years of euphoria when he can see only the favorable possibilities of industries, companies, and their stocks to profound pessimism when he’s so depressed he can see nothing but trouble ahead.
Mr. Market persistently teases investors with gimmicks such as surprising earnings, startling dividend announcements, sudden surges of inflation, inspiring presidential pronouncements, grim reports of commodity prices, announcements of amazing new technologies, distressing bankruptcies, and even threats of war. These events come from his bag of tricks when they are least expected. Just as magicians use deception to divert our attention, Mr. Market’s very short-term distractions can confuse our thinking about investments.
Mr. Market dances before us without a care in the world. And why not? He has no responsibilities at all. As an economic gigolo, he has only one objective: to be attractive. Mr. Market constantly tries to get us to do something — anything, but at least something — and the more activity, the better.
Whichever version you prefer, the story is a good one to go back to from time to time. Market fluctuations can draw you into doing something that works against your best interests. It’s best to ignore it most days.
But that’s easier said than done. Except, the story offers no specifics on how to avoid the temptation to act in the first place. Ellis has a few suggestions to consider.
First, know your history:
The best defense against Mr. Market’s seductive tricks is to study stock market history — just as airline pilots spend hours and hours in flight simulators, practicing flying through dreadful storms, landing at unfamiliar airports, and dealing with mechanical malfunctions so they are well prepared to remain calm and entirely rational when faced with such situations in real life. (They also learn not to take events personally and not to become emotionally involved, knowing that surprises are not surprising: They are actuarial expectations on a bell curve.)
Second, know yourself:
Know thyself is even more important, and all investors will want to recognize the central lessons of behavioral finance…
If Mr. Market can’t get you to be overly optimistic by showering you with good news and promises, then can he worry and even scare you with bad news and threats? We all have weaknesses, and Mr. Market knows where and when to push our buttons.
Risk tolerance differs for each investor. And the worst time to learn your risk tolerance — the limit to which you can absorb risk without experiencing the anxieties that produce irrational behavior — is when you are there for the first time or are without preparation. This is why fire drills make sense, and why investors will benefit from studying past market behavior, so they can estimate their own “what if” behavior and protect themselves from getting caught outside their personal comfort zone.
Finally, have a long term plan:
For every investor, there is a best-fit long-term policy, and your following that best policy takes nothing away from any other investor…
The really hard part about investment policy is not figuring out the best feasible combination. While it takes some time and analytical discipline, this part of the problem-solving is far from advanced science.
The really hard part is managing ourselves: our expectations and our interim behavior. Walt Kelly’s Pogo puts it as “we have met the enemy and he is us.” Most investors are too optimistic about the long run and much too optimistic about how well they will do compared to the averages, so they set themselves up for disappointment…
Three parts of investment policy are important:
- Deciding the right asset mix for the particular investment fund.
- Accepting and working with the reality that each investor’s long-term gross returns for each asset class will very likely be “average” for that asset class — minus manager fees, taxes, and so on — and accepting the corollary reality that underperforming is much more likely than outperforming.
- Sustaining policy commitments at market highs and at market lows, exactly when that rascal Mr. Market is doing his very best to do his worst.
The reality is that “roughly right” is all we can ever hope for on long-term asset mix, because even the most sophisticated investors must make their judgments on the basis not of facts, but on probabilistic estimates of two great uncertainties, markets and human reactions to markets, and without knowing the consequential leads and lags that will surely be part of the real world.
These days there are very few things that offer an advantage in terms of returns. Only two stand out in my mind (and will continue to stand out):
- Better Behavior – Be more disciplined than the rest of the market.
- Long Term Bias – Since the majority of the market is hyper-focused on the short term, do the opposite.
So keep your eye’s on the horizon. Don’t worry about what everyone else is doing. Build a portfolio around you’re strengths and weaknesses. But be careful to not let your portfolio stray too far from your risk tolerance. Doing so will make it less tempting to deviate from your plan. Because even though Mr. Market has matured, he’s deceptively tempting and chaotic as ever. The mood swings are here to stay.
The Winner’s Game
This post was originally published on August 30, 2017.