If there is one thing that characterises share prices, it is that they can go up and down, and often so. This high volatility is the cause of much fear and resistance to investing; you can lose your money as a result. However, the market and its price fluctuations can also work very much to your advantage. In this article, we look at Mister Market's famous metaphor, which teaches us how to deal with volatile markets.

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What is volatility?

In some years, share prices are rivers where an experienced white-water racer can easily go down. In other years, the same river is suddenly calmer and more stable. This is called the 'volatility' of the market: the extent to which the market fluctuates in a given period.

This volatility of the markets is one of the biggest topics in financial news. Put your TV on during office hours and you will see at the bottom a so-called 'ticker' with all the share prices with an arrow (and a percentage) next to it. These figures are coloured green or red to indicate, together with the arrow, whether the price has risen or fallen. To reinforce this, you will also find a few talking heads above the arrows, trying to explain the movements.

What exactly is volatility and what should we do with it?

The price of a share is actually determined by only one thing: supply and demand. How much people like (or do not like) a share is expressed in how much people are prepared to pay for it.

The next question is then: how do people determine how much money they are willing to pay for a share? A rational and economic attitude leads to the theory known as the Efficient Market Hypothesis (often abbreviated as "EMH"), or the "efficient market hypothesis" in the 'vernacular'. In short, this theory holds that all relevant information about a company is contained in its current share price.

This theory is based on a number of important assumptions. The first is that the investor is an essentially rational being. It is also assumed that everyone uses exactly the same logic. Finally, the theoretical basis of the EMH rests on the idea that all relevant information is available to everyone. After all, you can easily find the annual reports of the companies on their own websites (on the "investor relations" section). One plus one plus one becomes three and the EMH is born.

This homo economicus (man as a rational, calculating being who knows exactly what is good for him) is no stranger to modern economic theory. Indeed, it plays a hugely important role in all kinds of economic models. Including those of the market.

But human is more than a homo economicus. The human is also an emotional being. The belief that this will always remain separate from the rational side in market transactions is an assumption that has many flaws. It is often the case that the market is a fairly rational reflection of a company's value, but very often it is not. In addition, this is where the opportunities lie.

Benjamin Graham, professor at Columbia University in New York in the 1940s, also, saw this and decided to do something with it. He developed a completely new attitude for the investor towards the market. Part of this is a metaphor that teaches us to deal better with these volatile markets: Mister Market.

Meet Mister Market.

The key point from The Intelligent Investor is that an investor is more successful while investing if he can buy good companies at a discount. That is, a company (or parts of it, as is the case with stocks) is for sale at a price that is lower than what the company is worth.

To explain how this can happen, Graham introduces Mister Market:

"Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly."

Benjamin Graham

It says that Mister Market is a hypothetical partner in a company that you own with him. Every day he comes to you with a proposal: sometimes he wants to buy your share in the company and other days he wants to sell you his share at a certain price.

The idea is that Mr. Market is a rather volatile (perhaps bipolar) partner. He is often carried away by his emotions, which can change rapidly. If he is euphoric about the future, he will be happy to pay (and therefore a lot) for your part of the business: it can only get better. After a setback, whether from fear or general depression, he will be very happy for you to take over his share. He will give you a good price for it, sometimes too well.

A partner like this seems a nightmare for any businessman, as you want to do business rationally. "It's strictly business", it is sometimes said, meaning that something should not be interpreted in an emotional way.

But Graham didn't see it that way. Mr. Market can be seen as a blessing. This is because you never have to accept his offer. You can use his volatile behaviour to your advantage. You only accept his offer when it is lower than you think the company is worth, and you only sell when you think Mister Market is offering excessively much.

The real market.

This metaphor may sound all very nice as a story, but does it connect to the real world? Surely most people are not as bipolar as Mister Market?

There is certainly something to be said for that, the average person has a lot less violent mood swings than this one hypothetical individual does. But that does not mean that the market always behaves in a rational and responsible manner.

The main explanation for volatile markets is that people are not perfect at analysing information. Decision-making is often done using all sorts of irrational, unconscious 'biases' (roughly translated as 'prejudices' or 'tendencies'). Much academic work has been done on this by, among others, the Nobel Prize winners Daniel Kahneman (he received the prize for work he did together with Amos Tversky) and Robert Shiller (see, for example: here and here). Since stock markets are pre-eminently a human affair, they do not escape our innate irrationality.

There are plenty of examples when the market undervalued or overvalued a particular company. The internet bubble of the late 1990s and early 2000s is a good example of the latter (more on this bubble here). An example of the former is also not far off: the crash of '08-'09, 1929, or the corona situation in 2020.

Conclusion

Over the past decades, many smart people have addressed the issue of volatile markets and the right investor behaviour. From Nobel laureates to wildly successful investors, they have all taught us how to deal with volatile markets.

The most important lesson we can learn from the work and achievements of these people is that we must always keep a good attitude ourselves. Be aware of your own psychology and always try to approach investing rationally. How well you do this will largely determine your success as an investor.

Books

Malkiel, B. G., 1973, A Random Walk Down Wall Street.

Graham, B., 1949, The Intelligent Investor.

Shiller, R. J., 2000, Irrational Exuberance.

Kahneman, D., 2011, Thinking, Fast and Slow.

Ariely, D. & Kreisler, J., 2017, Dollars and Sense: How We Misthink Money and How to Spend Better.

About Alexander Kelm

Alexander Kelm is a passionate value investor and runs the website Wall St. Nerd. Here, the passionate value investor writes in-depth articles on the topic of Value Investing. Value Investing involves analyzing a company's fundamentals and can be characterized by an intense focus on a stock's price, its intrinsic value and the relationship between the two.

Alexander Kelm offers online courses on stock investing.

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