Thursday, April 19, 2012

Scared of market volatility? Read this

Legendary investor Warren Buffett is known to pay little heed to movements in the stock markets. He often urges investors to focus solely on buying great businesses. For him, stock prices are nothing more than entry and exit points. But the kind of wild swings that stock markets often witness can give shudders to many loyal adherents.

Why are stocks markets so insanely volatile? Do the underlying fundamentals of a business, or an economy at large, change every few seconds? Why do investment managers engage in excessive trading that often sends markets in a tizzy? Wouldn't following Buffett's wisdom help them create wealth for their clients?

Jeremy Grantham of GMO, a global investment management firm, has an interesting perspective to present. He cites 'career risk' as one of the most important factors driving investment behaviour. As per him, professionals who manage other people's money are primarily driven by the imperative to protect their own careers than to make money for their clients. If an investment manager were to make a mistake of his own, there would be a good chance of him losing his job. But what if he made a mistake that everyone was making? Most likely, he would be pardoned. This incentivises them to pay close attention to what other investors are doing. And very often, they merrily follow the herd. But this act of aping other investors gives enormous momentum to stock prices, driving them either too expensive, or too cheap.

Individual investors who invest their own money have a tremendous advantage over investment managers. Unlike the latter, investors have no compulsions that would force them to make hasty decisions. They can afford to make their own mistakes without the threat of losing their jobs. So do not be perplexed by the volatility in stock markets. Instead use it to your own advantage. Buffett comes in handy yet again when he says, "Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

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