How to think about volatility

Below is what Warren Buffett wrote in early 1987–months before the crash in the fall of that year. It has helped us over the years to deal with extremes of optimism and pessimism among day traders and other speculative types. These are the people (or computers) that determine the value of public companies on a daily basis.

Buffett believes that the stock market can be thought of as a manic/depressive institution, and that’s how it looks to us. Little has changed since 1987, except that we’ve found new ways of accelerating the transition between manic and depressive behaviors.

Right now, we think the market is leaning toward the optimistic side, but someday it will go the other way. The following helps us keep our emotions under control, and we hope it will help clients do the same.

The Parable of Mr. Market

From the 1987 Berkshire Hathaway Annual Letter to shareholders

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be the most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market, who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest in the business or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and we can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

In one significant way, things are worse than back in 1987. Financial journalism has been transformed by the 24-hour news cycle and click-bait headlines. Now the financial press provides constant “reasons” for Mr. Market’s behavior without understanding that they are providing rational camouflage for an emotional basket case.

Best regards,

Daniel A. Ogden