How Ignoring Mr. Market's Mood Swings Can Increase Your Wealth

The great Benjamin Graham liked to refer to "Mr. Market" to explain the movements of stock prices. Imagine, Graham suggested, that Mr. Market is your business partner, and every day he shows up and offers to buy your interest in the business or sell you his. Graham, a Columbia University professor, wrote his seminal The Intelligent Investor in 1949 and literally taught Warren Buffett everything he knows about value investing.

Buffett's reading of Mr. Market is that he has "incurable emotional problems." Some days he feels euphoric and names a high price for his share. Other days, he's depressed and wants to unload his share for a pittance.

Given his neuroses, there's danger in listening to Mr. Market's advice. But Mr. Market is treated as a sacred oracle by many members of the financial media, who act like shamans trying to divine meaning from his every utterance, even when he's just clearing his throat.

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Every day, the media assign market movements to random events -- and sometimes even attribute different market shifts to the same event. I remember one day when the consumer confidence number was announced and the market immediately went up. That was because it was encouraged by the report, according to a media shaman. But, uh-oh, at midday the market was down because the report wasn't as strong as expected. And by day's end, the market was mixed because it didn't know what to make of the report. The real reason for the market's ups and downs could have been that Mr. Market was having a bipolar day.

Mood Swings

Listening to Mr. Market may be foolish, but knowing whether he's euphoric or blue could be mighty useful. You could buy low and sell high, or at least not be swayed by the media's reading of Mr. Market's tea leaves.

Such an understanding is not a science -- yet. But those who study behavioral finance have made some headway. They've taken the well-documented biases that mess up the ability of individuals to make decisions and tried to apply them to the market as a whole. Two of the most powerful biases are that we fear losses more than we like gains, and that we're affected much more by recent performance than we are by long-term past performance.

Through some statistical legerdemain, these biases were combined to make an investor-sentiment index by two professors at the University of California at Santa Cruz, Daniel Friedman and Ralph Abraham. Colleague Todd Feldman, now a professor at San Francisco State University, tested the index on mutual fund market data.

The indicator shows why the market is slow to inflate and why crashes come hard. When the market is slowly rising, fund managers gradually build riskier portfolios. But a market downturn scares investors, prompting them to sell fund shares. That forces managers to sell stocks, depressing prices and scaring investors into more selling -- a vicious circle.

The lesson for investors: Don't be persuaded to take on more risk by a rising market. The increase may be fueled by higher profits, but the market may also be inflated by a fragile euphoria that can quickly turn into depression and decline.

Feldman also made an interesting discovery that should be a cold slap to those who fixate on financial news. Commentators often quote the consumer confidence index and the put-to-call and advance-to-decline ratios when predicting short-term price movements. But Feldman found that none of these measures had predictive value in the short run.

Feldman also has a theory about why the markets have been so volatile in recent years. Both biases have always swayed the markets, he believes, but they were limited by the amount of money that could be invested. "But now those constraints have been lessened because of the evolution of leverage and derivatives."

In other words, Mr. Market is on speed.