U.S. Markets closed

Graham and Buffett on Profiting From Market Irrationality

- By John Engle

While market structures have changed a great deal over the years, the key players, human beings, have not changed much at all. Understanding this fact can offer investors timeless wisdom, as well as actionable behavioral insights. By exploiting the natural human tendency to follow the crowd, thoughtful investors can reap rich rewards.

Graham tells us to conquer our emotions

Benjamin Graham, the father of value investing, is best known for his advice that investors look to companies' fundamentals, rather than rely on sentiment. Despite his dispassionate attitude, however, Graham was also a student of human nature and its impacts on financial markets :

"Though business conditions may change, corporations and securities may change and financial institutions and regulations may change, human nature remains essentially the same. Thus the important and difficult part of sound investment, which hinges upon the investor's own temperament and attitude, is not much affected by the passing of years."

Graham understood full well that markets are fundamentally human enterprises, a fact that has not changed even in this era of quantitative investing and high-frequency trading. Human nature is slow to change, if it can really change at all.

Buffett says we can exploit others' emotions

Warren Buffett (Trades, Portfolio), unquestionably the most successful of Graham's students, has spent decades putting his mentor's teachings into practice at the helm of Berkshire Hathaway Inc. (BRK-A)(BRK-B).

In various writings, Buffett has addressed the subject of Mr. Market, a personification of the mass of market actors originally devised by Graham. According to Buffett, Mr. Market is prone to wild swings in emotions, which a level-headed investor can exploit :

"Sometimes he is euphoric and sees only favorable outcomes and hence names a very high buy-sell price. Other times he is depressed and sees only negative outcomes and provides a very low buy-sell price. Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful."

While Graham was more focused on the conquest of his own biases, Buffett has made a career of profiting from the biases of others.

Overcoming the pressure of the crowd

It takes enormous emotional fortitude to keep one's head when everyone else has lost theirs, as Michael J. Maubossin has pointed out :

"Most of us have a powerful desire to be part of the crowd and an aversion to being separate from the crowd. The psychological pull to conform is strongest at the extremes of fear and greed."

Understanding when the crowd has turned to euphoria or panic is hardly a simple matter. But it can be done.


For Graham, the key is to recognize one's own behavioral biases and irrationalities in order to conquer them with reason. Buffett takes this thought a step further, arguing that it is possible to profit from the market's occasional bouts of irrational euphoria.

Of course, this is easier said than done. But, if you can manage to overcome your emotional, the payoff can be massive. It certainly seems to have paid off pretty well for Buffett.

Disclosure: No positions.

This article first appeared on GuruFocus.