Sunday, January 27, 2008

Enduring Volatility - Dealing with Mr. Market's Mood Swings

Of late, the stock market has been experiencing wild volatility. Experts (those who study stock market theories such as EMH) say that this means risks have correspondingly increased because after all, volatility equates risk, doesn't it ? For value investing, risk has a totally different definition: that of permanent loss in the value of your holdings. Thus, true investors do not equate volatility with risk; instead, they see it as golden opportunities to purchase part-ownership in companies with strong, stable earnings at fire-sale prices. Volatility should be embraced as a friend of the value investor, because it periodically under-prices companies so ridiculously that they almost beg to be bought !

Benjamin Graham (the father of value investing) wrote in this book "The Intelligent Investor" Page 203 that investors who "permit themselves to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage". He created the perfect market allegory called "Mr. Market" to explain the wild swings and volatility sometimes observed in the stock market, and this is by far the most apt and appripriate analogy of human behaviour and psychology that there is. Mr. Market is seen as an individual who is willing to buy or sell you a stake in a company at a given price daily. The fundamentals of the business may remain stable and even boring; but Mr. Market's moods can be highly volatile, swinging from manic-depressive to overly-optimistic one moment to the next. As we have seen in Jan 2008 thus far, he has been extremely pessimistic and is offering low prices for most companies, regardless of the valuations and fundamental characteristics of each company. As investors, we should laugh and scoff at his irrational behaviour because who would bother selling something cheaply to a madman who is prone ot wild mood swings ?

Sadly, most people fall under the influence of volatility (Mr. Market's moods) and become affected emotionally by them. As an investor, being able to perceive the true value of a company is an enormous advantage as it allows you to know what price to buy or sell a company; thus making Mr. Market your servant instead of your master. Human beings are emotional creatures and more so when it comes to finances (money) as it can be seen as an extension of one's ability and ego. Thus, investors allow themselves to be stampeded by the madness of crowds and be influenced by Mr. Market's mood swings, and it is their financial loss which becomes the financial gain of those who understand the true value of a business and are willing to take a long-term view.

The recent sharp market selloff did not have much effect on me, as I chose to totally ignore Mr. Market's perception of the true value of my companies. Within myself, I had confidence that I understood the business well enough and that nothing adverse was happening to them; thus I welcomed lower prices so that I may purchase more of the company at a margin of safety. My principle is to avoid companies which I did not thoroughly research on; thus I avoided most of the companies even though prices were attractive as I did not wish to compromise my principles. An opportunity cost is always better than investing in companies which you had no full understanding.

Another paragraph in "The Intelligent Investor" says that a "man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement". Essentially, this is telling us not to monitor the prices of our companies like a hawk, as there is no need to if the business is doing well. The problem with most investors and speculators is that they are too focused on price instead of value. Oscar Wilde once said that "people know the price of everything, but the value of nothing", and this is very true when it comes to the market. If people assessed a company based on value instead of price, then they would have different perceptions of whether to buy a company or not. It is ridiculous to see postings in forums which say that "hey look ! The price of the shares have gone up so it must be a good company !". That must be the most shallow observation I have seen thus far, and likely to cause the person who uttered it much pain and sorrow, as he does not comprehend the concept of margin of safety.

At the risk of sounding overly preachy, risks actually DECLINE when prices fall and RISE when prices rise. Most people think of it the other way, which is why volatility has such a bad name to it. If people saw volatility as a way of buying shares of companies cheaply, then they would welcome volatility. Of course, such moves have to be combined with sound and objective judgement, a long-term view as well as a knowledge of margin of safety. For those concepts, I suggest reading and re-reading "The Intelligent Investor" as a reminder. This book's concepts hold true in the current market turmoil and will continue to act as a beacon of light for those who are looking for a true path through the darkness and uncertainty.

10 comments:

HH said...

Hi MW,

Thanks for the reminder once again. There are so few value investors around. Your transformation from a trader to a value investor without any guidance (except from books) is truly amazing.

(My mentor was a trader for 9 years before all his money was wiped out in 1997 crash. Had he been a value investors, those stocks would have moved higher than 97 level in 2000)

Chapter 8 and 20 are good reminders during market melt down.

Keep writing MW :)

MM said...

MW,

Interesting piece. Also HH's view of trader for 9 years and gets wiped out in 97 shows that HIS FRIEND IS JUST A POOR TRADER...

There are many kinds of traders... however, there are only one kind of trader who consistently make money.. those that understand that you don't fight the market trend and you don't average losses.

This bear mkt will test "so-called traders" and value investors alike... If this continues for another 9 months... I am VERY VERY sure that more traders will lose out and washed out of the mkt and more so called value investors will also get washed out..

Don't get me wrong... Value investors is a good strategy ( I must stress that I HAVE NO BONE to pick with value strategy :)), provided that the ppe. REALLY KNOW what they are doing.. like you do...

That is why you deserve my respect to be disciplined to your strategy, as I stick to mine ;)

Too many ppe. learn a little bit and called themselve value investors and they buy and hold their way to suicide.

I am still out of the market in full cash and learning how to short it..

This correction is not going to be over that soon.

Cheers,
MM

linda said...

Hi very good article that you have put out. And timely too. Somehow I was calmed by this article of yours. Yes I am stuck with some stocks, some bought at quite high prices. Sadly I picked some more two days ago to be stucked again. Will not be checking stock prices so frequently from now onwards. Thank you for penning such a useful piece.

HH said...

MM,

You are right! We both are horrible traders. I lost SO MUCH until I dare not even keep track.

Hope you make heaps shorting the markets.

musicwhiz said...

Hi HH,

You are welcome, and thanks for visiting. Will continue to write as long as I can keep up the inspiration for articles haha ! Guess your mentor had to learn which style was more suitable for him in the end. :)

Regards, Musicwhiz

musicwhiz said...

Hello MM,

Thanks for your comments, yes I also believe this correction will not be so short, and will probably last at least 9 months to 1.5 years perhaps ? I am glad for my margin of safety though I am still new to value investing and am still learning as I go along. I will have to stay alert and possibly modify my value investing style as time goes by, in order to stay relevant. Thanks for the advice !

You seem very good at what you do, wishing you all the best in shorting the market !

Regards
Musicwhiz

musicwhiz said...

Hiya Linda,

Thanks for visiting too !

Cheers,
Musicwhiz

musicwhiz said...

Hi HH,

I guess losing money is much easier to do than earning it, especially in the stock market. Most people I personally know of do not think of the downside risk, only the potential gain. This is dangerous and usually results in permanent loss of capital for them.

Hope to learn more from you and your mentor as time goes by !

Regards, Musicwhiz

Steven said...

hi,

this website is cool...

i am new in this.

how can i start learning..


do use Value Investor product from Spireframe Software LLC?

http://www.spireframe.com/products/

how is it? where can get the files to import w/o keying?

musicwhiz said...

Hi Steven,

Thanks a lot for visiting. Not sure about the spire thing you are talking about. Could you elaborate more please ?

Thanks,
Musicwhiz