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Berkshire Hathaway
Red Wire - Green Wire

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By rclosch
March 28, 2002

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The problem with the Efficient Market Theory is that looks at the market as a computer, a machine that collects all the information about a stock or a commodity and spits out a rational price that accurately reflects the correct value of whatever is being traded. Markets are wonderful at collecting and transferring information; at any particular moment the price of the last trade reflects the all the knowledge of all the participants in that market. This means the market is smart. It is very efficient at gathering information. In my 35 plus years of watching I have run across many, many people who thought they were smarter than the market, but you know what? They never were. But just because markets are efficient at managing information, it does not mean they are rational.

It is hard for me to take EMT too seriously because it leaves us with no explanation for Benjamin Graham's Mr. Market, the bi polar partner of every shareholder. Graham's metaphor has always been helpful for me, so the question is how can a market be bi polar and rational at the same time? Also, if markets are always efficient why do bubbles pop and why to bear markets climb their wall of worry? The Stock Market is mostly efficient but is also, at times, it is very emotional.

So, I would like to purpose a modest revision to the model of market behavior. The market is not a computer but an organism, an organism that is made up of the intellect and the emotions of all the market participants. The organism is constantly changing, given to rapid growth during bull market, but plagued by the grim death of many cells in a bear market. Change is constant, every time someone adds money to the market or removes part, or all of his capital the market changes a little. People die; new people open accounts every day.

The Important Part

But here is the important part, the part that EMT ignores. The market organism also changes constantly because the emotional status of the participants changes. People react to events in ways that are both rational and emotional. So a change in the market price may be caused by new information about the stock, or it may just as easily be caused by the level of fear or greed prevalent among the participants.

I like this Model for market behavior first of all, because it fits the "Mr. Market" construct, but also it helps to explain long market cycles. Markets have memories but the memory is collective and changes as old participants leave and new people enter. The market is more impacted by things that happened yesterday than things that happened forty years ago

The farther we get away from a traumatic market event such as the 1973-1975 bear market that saw the Dow correct by 50% the less is the impact of that event on current market psychology. Every time someone who was participating then leaves it removes that person's input from the collective market memory, so the organism changes. For me this helps to explain the long market cycles that we experienced in the Twentieth Century.

It takes a long time for a new bull market top work up a good head of steam because at first Mr. Market still remembers that last crash. But by 2000 there were not many people still playing who experienced the seventies, and whole lot investors that had been playing for ten fifteen maybe even twenty years and never experience a serious long term bear market. So by 2000 you had a totally different organism than you did in 1985. Fifteen years means a lot of people have left and a lot of new people are playing, so you have a whole new set of cells.

Red Wire - Green Wire

If you study the characteristics that make Warren Buffett a successful investor, you see that he does not try to be smarter than the market, but limits his activity to simple businesses were long term trends are easier to predict.

Combined with this passion for simplicity is an emotional disposition that is different from most people. When the normal investor is fearful Warren is bold, when the market is bullish Warren is afraid. It is almost as if he were the beneficiary of some genetic mutation that cross wired his emotional reactions. If all normal people (including particularly those that populate Wall Street), are born with their emotional green wire attached to another green wire. Then, Warren was born with this pattern reversed and his green wire came connected to a red wire. So at those particular times that Emotion seems to be running a market, Warren is doing exactly the opposite of what a normal investor is doing.

In no way would attempt to deny Mr. Buffett's prodigious intellect nor the importance of his research, but his emotional discipline allows him to have better results than the market averages even without trying to be smarter than the market. The key is try to avoid doing anything stupid, and at the same time find a way to use Mr. Market's psychosis to your own advantage.


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