Diagnosing Mr. Market

At a glance

  • The market’s movements often belie rational value parameters. These idiosyncrasies were famously captured as Mr. Market by Ben Graham in his seminal book ‘The Intelligent Investor’
  • Mr. Market is manic-depressive, offering unreasonably high and low prices during times of optimism and pessimism respectively
  • These extremes are explained by behavioral biases inherent in investor behaviour, ranging from overconfidence to trend-chasing
  • We’re all susceptible to these biases but being aware of them helps reduce their impact on our wealth-building goals

The Calm Investor | What investment results depend on

In the post on why stock prices move in the long-term, I mentioned how the opportunities for the calm investor arise out of deviations of stock prices from their fair values.  And in ‘Don’t drink from the fire hydrant’, I wrote of the “surly old caretaker” who makes a mess of “expected” outcomes for markets.

Many readers would have realized the similarity to “Mr. Market”, often referred to by the world’s most famous investor, Warren Buffett. Mr. Market first made his appearance in ‘The Intelligent Investor”1, that seminal work on investing by Benjamin Graham. His role is to turn up at your door every day and offer you a price at which he’s willing to buy or sell you a share of a business. Key is Mr. Market is manic-depressive.

When stocks are going up, Mr. Market offers even higher prices and when they are going down, he turns up in a panic, desperate to dump them all at rock bottom rates.

In that little explanation, Graham so elegantly encapsulates the collective irrationality that is an essential part of the stock market, which also makes it highly volatile and unpredictable in the short term.

The reason to try and diagnose Mr. Market is not as an academic study but to understand ourselves. It took me years to even become aware, let alone counter, my strong urge to buy, on days when the stock tickers showed green (up) all the way. There’s a little bit of Mr. Market in all of us.

One paper, ‘Effect of behavioral biases on market efficiency and investors’2 welfare’ by Terrance Odean, Professor of Banking and Finance at University of California is an excellent compilation of the biases that afflict individual investors.

Summarized here are some of the key takeaways from Prof. Odean’s paper:

Overconfidence

The state of believing that your information is more accurate and precise than it is and that your investment ability is outstanding when it really is not

How it manifests itself

  • Trade more frequently believing it to be better than buy-and-hold
  • Tend to underdiversify since they see no reason to hedge

Chart shows a study done on over 66,000 investor accounts by Prof. Odean with investors classified into groups based on the extent of monthly portfolio turnover, higher the turnover, higher the number of buy-sell trades. The inverse relationship between the amount of activity and the annual returns is stark.

Interesting sidenote: In a follow-up study, Barber and Odean were able to establish that men are more likely to be overconfident investors than women.

Disposition Effect

Also known as Loss Aversion, it refers to the tendency to postpone selling losers to avoid experiencing the regret of loss

How it manifests itself

  • Selling winners and holding on to losers

Chart shows the ratio of trades selling winners over losers from a sample of brokerage accounts. A value of 1 implies equal number of winners and losers were sold. The ratio stays consistently over 1.3 for most of the year before declining in December, due to the rush to harvest tax-losses. The deviation in December is particularly indicative of this bias as once the investor decided it was a bad decision, the sale could have been done at any point in the year to harvest the tax loss but they tended to leave it until the last month to bite the bullet.

Limited attention

There are limits to how much information we can process, and facing many choices is an uncomfortable situation

How it manifests itself

  • Investors buy from a sub-set of “attention-grabbing” stocks

Using high abnormal trading volume as a proxy for investor attention where a higher percentage of individual investors were on the buy side of the transaction (as opposed to institutions) on days that those stocks were in the news.

This is applicable to both “value” and “momentum” buyers, except that each set might end up buying different stocks from set of “attention-grabbers”

Another way this impacts the markets is that investors pay more attention to a rising market and therefore are more likely to buy in a bull market. (that explains my urge to buy on rising days!)

Lesson for an investor is that when a company is being spoken about in the media is the time to stay away from the stock given the added interest from other investors

Chasing Trends

Tendency to rely on short-term history to make decisions

How it manifest itself

  • Buying stocks that have performed well in the previous year
  • Investing in mutual funds that performed the best in the previous year

This is explained by our tendency to see patterns where none exist, and expecting them to persist into the future.

While we’re all still susceptible to the biases listed above, being aware of them will help take corrective action so that when Mr. Market comes knocking with premonitions of doom or irrational exuberance, we can smile and make it work for ourselves than succumbing to his biases.

References (external links):

The Intelligent Investor – Benjamin Graham, Jason Zweig, Warren Buffett

Effect of behavioral biases on market efficiency and investors welfare – Terrance Odean (Prof. Banking and Finance at University of California)

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