It was way back in 1987 that Warren Buffett shared the parable of Mr. Market in Berkshire Hathaway’s annual report.
Mr. Market was the creation of Buffett’s mentor, Benjamin Graham, who pioneered value investing and taught a class at Columbia University where he retold the story to his students, including Buffett.
In the parable as told by Buffett, you should imagine Mr. Market as your remarkably accommodating partner in a private business. Every day, he quotes a price at which he’s willing to either buy your piece of the business or sell you his.
The business is stable, but Mr. Market is not. “At times he feels euphoric and can see only the favorable factors affecting the business,” Buffett wrote. “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.”
The moral of the parable is that “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.”
This year, Mr. Market has been very depressed indeed. He can only see trouble from high inflation, rising interest rates and geopolitical tensions.
It’s not surprising that many people fall under Mr. Market’s emotional sway. Certainly, the business media’s coverage of the daily ups and downs of the market push people in that direction. And since Buffett retold the Mr. Market story, our understanding of the role of investor psychology has been refined by discoveries in the field of behavioural finance. For example, we know people are prone to loss aversion, the tendency to feel the pain of losses much more intensely than the pleasure of gains.
In calm times, most people understand that selling low is not a path to long-term investing success. But, in the heat of the moment, bailing out can be framed in deceptively tempting ways. One of these is to tell yourself you’re simply readjusting your asset allocation (even though there have been no major changes in your lifestyle or plans). Another is to decide you should “reduce your exposure to the markets until things quiet down.”
Temptation to sell is fed by the fact that each market downturn looks different. In 2008, the world appeared headed for a collapse of the financial system. During the 2020 pandemic crash, the entire global economy seemed be grinding to a prolonged halt. Today, rising interest rates look like they’re going to throw the economy into a recession.
The stock market doesn’t look backward to problems that have already occurred, but ahead to future expected earnings. In past downturns, the markets began to recover well before economic indicators turned positive. And the early days of a market recovery typically produce some of the largest gains. Missing out on those returns can have a dramatic impact on your overall performance.
It not easy to keep your cool when markets are falling. That’s why planning an asset allocation that matches your financial situation and risk tolerance is so important. In our practice, every client has a tailored allocation to safe, short-term bonds that protects their ability to spend in the coming years, regardless of what markets do. This allows us to avoid selling stocks that are down.
From there, disciplined portfolio rebalancing is the key to profiting from market swings. Our rebalancing discipline dictates that when a portfolio’s desired allocation is off by more than 5%, we rebalance to return it to the target weightings. For example, if the equity portion of a 60-40 portfolio dropped to 55% or less, we would buy stocks to bring it back up to 60%.
Additionally, if underlying allocations like Canadian, U.S. or International equity are off by more than 25% of the target, this also prompts a rebalancing. So, if there’s a Canadian equity target of 10% and the weighting falls below 7.5% or above 12.5% that would trigger a rebalancing.
Rebalancing is a proven way to increase returns without incurring higher risk. It’s the best way to put Mr. Market in his rightful place – serving your long-term financial goals.
