How market behavior is similar to a person with mental illness

Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.

— Charles Mackay, in the preface to Extraordinary Popular Delusions and the Madness of Crowds,1852.

He made the first reflecting telescope, invented calculus, solved the mystery of gravity, created the laws of motion and his 1687 book Principia laid the groundwork for modern science.

He is often called the smartest person to ever live, but Sir Isaac Newton nearly went broke investing in the South Sea Bubble of 1720-21. An experience which famously caused him to lament: “I can calculate the motions of heavenly bodies, but not the madness of people.”

All investors and traders can relate to Newton’s exasperation. How often, after witnessing the irrational gyrations of market prices have you shaken your head and said: This market makes no sense -- it’s crazy!

Mad, irrational, insane, crazy. All of these terms can be used to describe market behavior at times. It begs the question: Is the market mentally ill? Or more precisely, do markets in fact exhibit behavior similar to that of a person with mental illness?

In a 2010 paper entitled “Does Mr. Market Suffer from Bipolar Disorder?” James H.B. Cheung asserts that, like individuals who experience the severe mood swings of bipolar disorder, investment markets are characterized by moods that range from major depression to mania. Cheung postulates that knowing the “mood state” of a market can help an investor identify optimal entry and exit points and also avoid the devastating losses caused when bubbles burst.

Understanding and identifying the cyclical emotional extremes of a market gives an investor the advantage over those unknowingly swept up by mania or blindsided by crashes. Each stage of Cheung’s Market Mood Model has unique implications for investor behavior, market trends, investor feedback mechanisms, expected returns, risk management, and optimal investment strategies.

Cheung's market mood model and the role of Graham and Bufferr

Cheung is not the first to compare markets to human emotional states. In his classic investment book The Intelligent Investor, Benjamin Graham created the parable of “Mr. Market” to illustrate an approach for managing the emotional whipsaws of investing:

"...Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. "

Warren Buffett, a disciple of Benjamin Graham, and the third richest man in the world, has called discovering The Intelligent Investor when he was 19 one of the luckiest moments of his life, because the book gave him the intellectual framework for investing. And Buffett's favorite part of the book is Chapter 8 -- where Mr. Market is introduced.

Here’s what Buffett had to say about “Mr. Market” in 1997:

...sad to say, the poor fellow has incurable emotional problems. At times he falls euphoric and 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... Under these conditions, the more manic depressive his behavior, the better for you.”

Manic depression is now known as bipolar disorder -- a diagnosis that is not trivial for those affected. According to the National Institute of Mental Health, every year Bipolar disorder affects approximately 5.7 million adult Americans, or about 2.6% of the U.S. population age 18 and older. It is a brain affliction that causes unusual shifts in mood, energy and activity levels, and can severely hinder the ability to carry out daily tasks.

Below is a chart of mood changes associated with Bipolar Disorder I, the most severe version of the disorder.

Here is the National Institute of Mental Health’s list of bipolar symptoms during manic and depressive episodes:

It is not a great leap to extrapolate the symptoms of bipolar disorder shown by individuals onto markets driven by the mass psychology of many individual investors. When Mr. Market is besieged by the above symptoms, it's little wonder that he makes irrational investment decisions.

In Graham and Buffett’s view, the intelligent investor should ignore the bipolar Mr. Market. Only if Mr. Market quotes a price way above or below intrinsic value should we pay attention. But be warned: Mr. Market's moods are deceptively contagious. The herding instinct is deeply ingrained in humans, and falling under the influence of the market’s mood should be avoided at all costs. If you think this is an exaggeration, know that Warren Buffett has long avoided keeping a live market price monitor in his office, lest his logic be corrupted by Mr. Market’s siren song.

Graham and Buffett have a value investor’s mindset -- concerned with what the underlying assets and operations of an investment is really worth, not it’s ever-fluctuating price as voiced by Mr. Market.

However that is not the approach of most investors. John Maynard Keynes, in The General Theory of Employment Interest and Money [1936], writes that the majority of investors, including expert professionals, are essentially in the business of predicting changes in the mass psychology of investors:

“[Investment professionals] are largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps,” but with what the market will value it at, under the influence of mass psychology, three months or a year hence.”

So as Keynes sees it, professional investors are generally occupied with trying to predict what the emotionally volatile Mr. Market will do next. While Graham and Buffett may call this folly, the fact is that, like Isaac Newton, most investors who make their own decisions are attempting to calculate the madness of people.

Because the mass psychology of markets moves through a generally predictable cycle, knowing where a market is in the cycle may give an investor an edge. Understanding of market mood phases may offer a framework for making profitable market decisions.

Cheung’s Market Mood Model uses the phases of bipolar disorder as a basis for identifying the phases which comprise a market’s emotional swings.

There are six phases of market mood in Cheung’s model:

1. Normal -- This is the base-building or consolidation phase where fundamentals are poor but stabilizing. Value investors are showing interest.
2. Hypomania -- Favorable news shocks hit the market, and prices break higher out of consolidation. Speculators, focused on short-term gains, begin buying. As the market continues higher, positive feedback ensues.
3. Mania -- The uptrend is very strong. Favorable analyst reports predict further gains, adding fuel to the fire. Sophisticated and novice investors alike are swept up in the market. Positive feedback is very strong as stories of big profits entice ever more speculators. Some smart money investors quit buying and begin to pare holdings, but consensus is overwhelming that more profits are to come.
4. Moderate depression -- The market peaks and begins to fall. Bulls become indecisive, and a narrative that questions the bullish story begins to build. Some buy on dips, expecting a rebound and further gains. Professionals increase short sales. Falling prices create a negative feedback loop. Investors begin to panic. Prices decline quickly.
5. Major depression -- The trend is very bearish and stories are resoundingly negative. Negative feedback mechanism is prevalent. Those who have not sold their positions in phases 3 and 4 are distressed and depressed, many “throw in the towel” and quit following the market.
6. Normal -- Selling has abated as bubble buyers have exited, but new buying interest remains weak. The market is “washed out.” Fundamentals are poor but beginning to stabilize. The market transitions back into phase 1 and value investors again begin accumulating, starting the cycle over again.

Knowing that the mood of the market is part of a cycle may help investors catch a trend early, before it becomes a bubble, and ride it profitably with appropriate risk management, expecting that market mania will inevitably cycle back to market depression.

While we may not be able to fully calculate the madness of men, an understanding of the bipolar cycle may help an investor do what Warren Buffett says is at the heart of his investment philosophy: “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”