Tulipmania and Mr. Market

First lets start with Mr Market, a classic investment analogy first explained in Bejamin Graham's book, The Intelligent Investor. The story goes something like this:

Imagine you own part of a business in partnership with a person named Mr. Market. Every day he tells you what your share of the business is worth and offers to buy your portion of the business or sell you an additional interest in the business. His views on the business swing from an incredible optimism to an overwhelming pessimism and anywhere in between. With this in mind the prices that he offers you gyrate as often as his moods do. When Mr Market quotes an incredibly high price, you might sell some of your stake in the business (or all of it if the price is right) whereas if the price he quotes you is low enough, you might decided to buy some of his stake (or all of it). However, any time the price is not right you don't have to do anything other than wait until he quotes you a price you are satisfied with based on your own ideas of what the business is worth.

This is such a simple explanation of the investment environment that we are in yet I wonder why so many investors fail to take this advice? Why any investor would sell a holding based on a declining stock price (i.e. stop losses) when the underlying "story" behind the investment has not really changed is hard to understand from a logical perspective. I often wonder whether this is because investors do not really understand what they are investing in and why.

However, I do understand that loss aversion and the games that it plays with your mind can get pretty intense at times. Even in the best case scenario, when there is a strong criteria driven business reason behind the investment, the thought of a declining stock price can make you want to sell. On the other hand, when there are a less than sound criteria behind an investment decision, a declining stock price can be hard to stomach.

Think about any investment where you felt there was a larger than normal element of speculation involved in the decision. When the price goes down on these speculative investments the first reaction is to SELL! The natural instinct against loss aversion starts to kick in. Without a set of real quantifiable investment criteria there is no way to measure the investment's price action against market events. Having this set of criteria will help to allow you to avoid investing based on emotions, tips, rumours and other psychological based biases. in other words, not knowing the underlying story behind a business and it's fundamentals gives an you very little psychological cushioning for seeing the investment through to the point where you realise the original reason for the investment in the first place.

To illustrate my point further, here’s a classic story about investor irrationality during the 1600s and the sad consequences for many of those involved. It kind of rings like the euphoric mania behind the internet stock bubble.

Tulipmania