6:00

flip-flop from optimism to pessimism

6:02

set off a significant stock

6:04

market route. The S&P

6:06

500 fell on three

6:08

consecutive trading days, August

6:10

1st, 2nd, and 5th, by

6:12

a total of 6.1%. The

6:16

replay of the mistakes I've witnessed for

6:18

decades was so obvious that I can't

6:21

resist cataloging them below. What's

6:24

behind the market's volatility? On

6:28

the first two days of August, I was

6:30

in Brazil, where people often asked me to

6:33

explain the sudden collapse. I

6:35

referred them to my 2016 memo on

6:37

the couch. Its key

6:39

observation was that in the real world,

6:42

things fluctuate between pretty good and

6:44

not so hot. But

6:46

in investing, perception often

6:48

swings from flawless to

6:50

hopeless. That says about

6:52

80% of what you need to know on the

6:54

subject. If reality

6:57

changes so little, why do estimates

6:59

of value, that's what security prices

7:01

are supposed to be, change

7:03

so much? The answer

7:05

has a lot to do with changes in mood.

7:09

As I wrote over 33 years ago in

7:11

only my second memo, the

7:13

mood swings of the securities markets

7:16

resemble the movement of a pendulum

7:18

between euphoria and depression, between

7:21

celebrating positive developments and

7:24

obsessing over negatives, and thus

7:26

between overpriced and underpriced. This

7:29

oscillation is one of the most

7:31

dependable features of the investment world,

7:34

and investor psychology seems to spend much

7:36

more time at the extremes than

7:39

it does at a happy medium. First

7:41

quarter performance, April 1991. Mood

7:46

swings do a lot to alter

7:48

investors' perception of events, causing

7:50

prices to fluctuate madly. When

7:53

prices collapse, as they did at the start

7:55

of this month, it's not

7:57

because conditions have suddenly become a bad

7:59

thing. bad. Rather, they

8:01

become perceived as bad. Several

8:05

factors contribute to this process. Heightened

8:08

awareness of things on one side of

8:10

the emotional ledger, a tendency

8:13

to overlook things on the other

8:15

side, and, similarly, a tendency

8:17

to interpret things in a way

8:19

that fits the prevailing narrative. What

8:23

this means is that in good

8:26

times investors obsess about the positives,

8:28

ignore the negatives, and interpret things

8:30

favorably. Then, when the

8:32

pendulum swings, they do the opposite,

8:35

with dramatic effects. One

8:38

important idea underpinning economics is

8:40

the theory of rational expectations,

8:42

described by Investopedia as follows.

8:46

The rational expectations theory posits

8:48

that individuals base their decisions

8:51

on three primary factors, their

8:54

human rationality, the information

8:56

available to them, and

8:58

their past experiences. If

9:01

security prices were really the result

9:03

of the rational, dispassionate evaluation of

9:05

data, presumably one piece of negative

9:07

information would move the market down

9:10

a little, and the next such

9:12

piece would move it down a

9:14

bit more, and so forth.

9:17

But instead, we see that an

9:19

optimistic market is capable of ignoring

9:21

individual pieces of bad news until

9:23

a critical mass of bad news

9:25

builds up, at which time

9:28

a tipping point is reached, the optimist

9:30

surrender, and a rout begins. Rudiger

9:33

Dornbusch's great quote about economics

9:35

is highly applicable here. Things

9:38

take longer to happen than you think they

9:41

will, and then they happen faster

9:43

than you thought they

9:45

could. Or, as my partner Sheldon Stone says,

9:48

the air goes out of the balloon much faster

9:50

than it went in. The

9:53

non-linear nature of this process suggests

9:55

something very different from rationality is

9:57

at work. particular,

10:00

as in many other aspects of life,

10:02

cognitive dissonance plays a big part

10:05

in investors' psyches. The

10:07

human brain is wired to ignore

10:10

or reject incoming data that is

10:12

at odds with prior beliefs, and

10:14

investors are particularly good at this.

10:18

While we're on the subject of irrationality,

10:20

I've been waiting for an opportunity to

10:22

share a screenshot from June 13, 2022.

10:28

This was a tough day in the markets. Interest

10:30

rates were rising thanks to the actions of

10:32

the Fed and other central banks, and

10:35

asset prices were under significant pressure as

10:37

a result. But

10:39

take a look at the table. Every

10:41

country's equity index was down

10:43

significantly. Every currency was down

10:46

relative to the dollar. Every

10:48

commodity was down. Only

10:50

one thing was up. Bond

10:52

yields, meaning bond prices were

10:54

down too. Aren't

10:57

there one asset or country whose value

10:59

didn't decline that day? What

11:01

about gold, which is supposed to do well

11:03

in difficult times? My

11:06

point here is that during big

11:08

market moves, no one

11:10

performs rational analysis or makes

11:12

distinctions. They just throw

11:14

out the baby with the bathwater,

11:16

primarily because of psychological swings. As

11:19

the old saying goes, in times

11:21

of crisis, all correlations go

11:23

to one. Further,

11:26

the data in the table exhibit

11:29

an additional phenomenon that's often present

11:31

during extreme moves. Contagion.

11:35

Something goes wrong in the US market. European

11:38

investors take that as a sign of trouble, so

11:40

they sell. Asian investors

11:42

detect that something negative is afoot,

11:44

so they sell overnight. And

11:47

when US investors come in the

11:49

next morning, they're spooked by the

11:51

negative developments in Asia, which confirm

11:53

their pessimistic inclinations, so they sell.

11:56

This is a lot like the game of telephone we played

11:58

when I was little. The message

12:01

may be miscommunicated as it passed

12:03

down the chain, but

12:05

it still encourages ill-founded

12:07

actions. When psychology is

12:09

swinging radically, meaningless

12:11

statements can be given weight. Thus,

12:14

during the three-day decline earlier this month,

12:17

it was observed that foreigners sold more

12:19

Japanese stocks than they bought, and

12:22

investors reacted as if this meant something.

12:25

But if foreigners sold on balance, Japanese

12:28

investors must have bought on balance.

12:31

Should either of these phenomena be treated as

12:33

more significant than the other? If

12:36

so, which one? Further

12:39

complicating things in terms of rational

12:41

analysis is the fact that most

12:43

developments in the investment world can

12:46

be interpreted both positively and negatively,

12:48

depending on the prevailing mood. In

12:52

this cartoon, a man

12:54

is sitting in his chair looking at a television

12:56

screen, and from the screen

12:58

the commentator is saying the following. On

13:02

Wall Street today, news of lower interest

13:04

rates sent the stock market up, but

13:06

then the expectation that these rates would

13:08

be inflationary sent the market down, until

13:10

the realization that lower rates might stimulate

13:13

the sluggish economy pushed the market up

13:15

before it ultimately went down on fears

13:17

that an overheated economy would lead to

13:20

a re-imposition of higher interest rates. Another

13:24

classic cartoon sums up this ambiguity

13:26

in fewer words. It's

13:29

highly applicable to the market tremor that

13:31

inspired this memo. Again,

13:33

a man is sitting in a chair watching

13:35

a commentator on the television screen. Everything

13:39

that was good for the market yesterday is no

13:41

good for it today. One

13:45

more source of miscalculation is investors'

13:47

tendency toward optimism and wishful thinking.

13:51

Investors in general, and equity

13:53

investors in particular, must, by

13:55

definition, be optimists. Who

13:57

other than people with positive expectations?

14:00

and or a strong desire for increased

14:02

wealth would be willing to part

14:04

with money today based on the possibility of

14:07

getting back more in the future. Charlie

14:11

Munger, Orrin Buffett's late partner,

14:13

routinely quoted the ancient Greek

14:15

statesman Demosthenes, who said, nothing

14:18

is easier than self-deceit, for

14:21

what each man wishes, that he

14:23

also believes to be true. One great

14:27

example is Goldilocks' thinking, the

14:29

belief that the economy will be neither strong

14:32

enough to bring on inflation, nor

14:34

weak enough to lapse into recession. Things

14:37

sometimes work out that way, as

14:40

may be the case right now, but not

14:42

nearly as often as investors posit.

14:45

Expectations that incline toward the

14:47

positive encourage aggressive behavior on the

14:50

part of investors, and

14:52

if this behavior is rewarded in good

14:54

times, still more aggressiveness

14:57

usually ensues. Rarely

14:59

do investors realize that a, there

15:02

can be a limit to the run of good news,

15:04

or b, an upswing can be

15:06

so strong as to be excessive, rendering

15:09

a downswing inevitable. For

15:12

years, I quoted Buffett as having

15:14

warned investors to temper their enthusiasm.

15:18

When investors lose track of the fact that corporate

15:20

profits grow at 7% on average,

15:22

they tend to get into trouble. In

15:25

other words, if corporate profit growth

15:27

averages 7%, shouldn't

15:30

investors begin to worry if stocks appreciate by

15:32

20% a year for a while, as

15:35

they did throughout the 1990s? I thought

15:38

it was such a good quote that I asked

15:40

Buffett when he said it. Unfortunately,

15:43

he answered that he hadn't,

15:45

but I still think it's an important warning. That

15:49

inaccurate recollection reminds me of

15:51

John Kenneth Galbraith's trenchant reference

15:53

to one of the most

15:55

important causes of financial euphoria,

15:58

the extreme brevity, of the financial

16:00

memory. It's this trait

16:03

that allows optimistic investors to engage

16:05

in aggressive behavior, untroubled by knowledge

16:07

of what such behavior led to

16:09

in the past. Further,

16:11

it makes it easy for investors

16:14

to forget past errors and invest

16:16

blithely on the basis of the

16:18

newest miraculous development. Finally,

16:20

the investment world might be less

16:22

unstable if there were immutable rules,

16:25

like the one governing gravity, that could be

16:27

counted on to always produce the same results.

16:30

But there are no such rules,

16:33

since markets aren't built on natural

16:35

laws, but rather the shifting sands

16:37

of investor psychology. For

16:40

example, there's a long-running adage that

16:42

says we should buy on rumor

16:44

and sell on news. That

16:46

is, the introduction of favorable

16:49

expectations is a buy signal,

16:51

because expectations often continue to

16:53

rise. That ends when

16:55

the news arrives, however, because the

16:57

impetus for gains has been realized

16:59

and no further good news remains

17:01

to take the market higher. But

17:04

in the carefree environment of a month ago,

17:06

I told my partner

17:08

Bruce Kars that maybe the prevailing

17:11

attitude had become buy on rumor

17:13

and buy on news. In other

17:16

words, investors were acting as though it

17:18

was always a good time to buy.

17:21

Rationally, one shouldn't price in

17:23

the possibility of a favorable

17:25

event twice, both when

17:28

the possibility of the event is introduced

17:30

and when the event occurs. But

17:32

euphoria can get the better of people.

17:36

Another example of the absence of meaningful

17:38

guidelines can be seen in this excerpt

17:41

from one of the oldest clippings in my file.

17:44

A continuing pattern of consolidation

17:46

and group rotation suggests that increasing

17:49

emphasis should be placed on buying

17:51

stocks on relative weakness and selling

17:54

them on relative strength. This

17:56

would be a marked contrast to

17:58

some earlier periods where exercising relative

18:00

strength proved to be effective. Loeb

18:03

Roads & Company, 1976. In

18:07

short, sometimes the things that have gone up the

18:10

most should be expected to continue to go up

18:12

the most, and sometimes the things

18:14

that have gone up the least should be expected

18:16

to go up the most. To

18:18

which many of you might respond, duh.

18:22

Bottom line, there are a few effective

18:24

rules for investors to follow. Superior

18:27

investing always comes down to

18:29

skillful analysis and superior insight,

18:32

not adherence to formulas and

18:34

guidelines. Volatile

18:37

psychology, skewed perception, overreaction,

18:41

cognitive dissonance, rapid-fire

18:43

contagion, irrationality, wishful

18:46

thinking, forgetfulness, and the

18:48

lack of dependable principles.

18:51

That's quite a laundry list of ills. Whether

18:54

they constitute the main cause of

18:57

extreme market highs and lows, and

18:59

are responsible for the volatile swings between them.

19:02

Ben Graham said that, in the long run,

19:05

the market is a weighing machine

19:07

that assesses the merit of each

19:09

asset and assigns an appropriate price.

19:12

But in the short term, it's merely a

19:15

voting machine, and the investor

19:17

sentiment that moves its swings

19:19

wildly, incorporating little rationality and

19:21

assigning daily prices that often

19:23

reflect little in terms of

19:25

intelligence. Rather

19:27

than try to reinvent the wheel, I'll

19:29

repeat some of what I've said in two

19:32

past memos. Especially

19:35

during downdrafts, many investors

19:37

impute intelligence to the market

19:40

and look to it to tell them what's going on and

19:42

what to do about it. This

19:44

is one of the biggest mistakes you can make. As

19:47

Ben Graham pointed out, the

19:49

day-to-day market isn't a fundamental

19:52

analyst. It's a barometer

19:54

of investor sentiment. You

19:56

just can't take it too seriously. Participants

20:00

have limited insights into what's really

20:02

happening in terms of fundamentals, and

20:05

any intelligence that could be behind their

20:08

buys and sells is obscured by their

20:10

emotional swings. It

20:12

would be wrong to interpret the

20:14

recent worldwide drop as meaning the

20:16

market knows tough times lay ahead.

20:19

It's not easy, September 2015. My

20:23

bottom line is that markets don't assess

20:25

intrinsic value from day to day, and

20:28

certainly they don't do a good job during

20:30

crises. Thus, market

20:32

price movements don't say much about

20:35

fundamentals. Even

20:37

in the best of times, when investors

20:39

are driven by fundamentals rather than

20:41

psychology, markets show what

20:44

the participants think value is rather

20:47

than what value really is. Value

20:50

is something the market doesn't know any more

20:52

about than the average investor. And

20:55

advice from the average investor obviously

20:57

can't help you be an above

20:59

average investor. Fundamentals,

21:03

the outlook for an economy, company, or

21:05

asset, don't change much from day to

21:07

day. As a result,

21:09

daily price changes are mostly about a. Changes

21:12

in market psychology, and thus b.

21:16

Changes in who wants to own

21:18

something or unown something. These

21:21

two statements become increasingly valid the

21:23

more daily prices fluctuate. Big

21:25

fluctuations show that psychology is

21:28

changing radically. What

21:30

does the market know? January 2016. The

21:34

market fluctuates at the whim of

21:36

its most volatile participants. Those

21:39

who are willing a. To buy at

21:41

a big premium to the former price

21:43

when the news is good and enthusiasm

21:45

is riding high and b. To

21:48

sell at a big discount from the

21:50

former price when the news is bad

21:52

and pessimism is rampant. Thus,

21:54

as I wrote in on the couch, every

21:57

once in a while the market needs a trip

21:59

to the shrink. It's

22:02

important to note that, as my partner John

22:04

Frank points out, in comparison

22:06

to the total number who own each

22:08

company, it takes relatively few

22:11

people to drive prices up during

22:13

bubbles or down during crashes. When

22:16

shares in a company that was worth

22:18

10 billion dollars a month ago trade

22:20

at prices implying a valuation of 12

22:22

billion or 8 billion, it doesn't

22:25

mean the whole company would change hands

22:27

at these prices, just a

22:29

tiny sliver. Regardless, a

22:32

few emotional investors can move prices

22:34

much more than should be the

22:36

case. The worst thing you can

22:39

do is join in when other

22:41

investors go off on these irrational

22:43

jags. It's far better

22:45

to watch with bemusement from the sidelines,

22:48

buttressed by an understanding of how

22:50

markets work. But

22:52

better still to see Mr. Market's

22:55

overreactions for what they are and

22:57

accommodate him, selling to him

22:59

when he's eager to buy, regardless of how

23:01

high the price is, and buying

23:03

from him when he desperately wants out.

23:06

Here's how Ben Graham followed the introduction of

23:08

Mr. Market that I included in the beginning

23:11

of this memo. If

23:13

you are a prudent investor or a

23:15

sensible businessman, will you let

23:17

Mr. Market's daily communication determine your view

23:19

of the value of your $1,000 interest

23:21

in the enterprise, only

23:25

in case you agree with him or

23:27

in case you want to trade with him? You

23:30

may be happy to sell out to him

23:32

when he quotes you a ridiculously high price

23:34

and equally happy to buy from

23:36

him when his price is low, but

23:38

the rest of the time you will

23:41

be wiser to form your own ideas

23:43

of the value of your holdings based

23:45

on full reports from the company about

23:48

its operations and financial position. In other

23:50

words, it's the primary job

23:52

of the investor to take note when

23:54

prices stray from intrinsic value and figure

23:57

out how to act in response.