The Motley Fool

How You Can Take Advantage of the Stock Market’s Extreme Swings

For any investor who first approaches the stock market, he may be surprised to find out that share prices can fluctuate wildly in the short-term, even though business values stay fairly constant over time.

The great Benjamin Graham, known as the father of value investing and who was also the mentor to Warren Buffett, used an allegory known as “Mister Market” to describe the violent fluctuations in stock prices on an almost daily basis. He likened it to a man who felt sad and despondent one day and offered to sell a stake in a business at a very low price, and he may come along another day and offer a really high price because he is feeling happy and jubilant.

The illustration is a powerful representation of the swing between optimism and pessimism in the stock market which I will discuss in detail below.

Pessimism And Melancholy

When there is bad news all around, and it seems nothing can ever get better, there will be a pervasive mood of pessimism and melancholy. It is as though storm clouds have gathered and no one can see any sign of the sun ever peeking out. Such a state of affairs usually accompanies a bear market as people feel despondent and are willing to pay low prices for the companies they own, even though some businesses may be chugging along fine. In such a depressing environment, investors should be looking to acquire great companies at beaten-down valuations.

Optimism And Bright Days

Conversely, when there is a lot of good news being reported in the financial media, investors feel optimistic, happy and exuberant. They can only see bright days ahead and cannot imagine things ever getting worse.

In such an environment, they willingly shell out money to purchase companies at high valuations, as they only predict a rosy future ahead. During such times, a prudent investor should feel cautious and hold back on buying companies with inflated valuations. He may even consider selling investments which seem over-valued based on traditional valuation metrics.

The Swing Of The Pendulum

The sometimes sharp swing between optimism and pessimism is a normal part of how stock markets function, and investors should be aware of this trait and take the Mister Market allegory to heart.

I like to think of it as a pendulum, similar to the type found in a grandfather clock. When the clock is ticking (i.e. the stock market is open for trading), the pendulum hardly rests in the middle but will always swing from side to side. Similarly, human emotion is also swinging from one extreme to the next.

The Foolish Bottom Line

Mister Market may be an emotional creature, but as investors, we should remain calm, objective and rational to evaluate companies for investments properly. We should do our best to take advantage of Mister Market’s mood swings, rather than be swayed by his emotions.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.