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Lindley Estes is a business writer for The Free Lance-Star and Fredericksburg.com. This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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Herd mentality foils market efficiency

RECENT trading patterns in the U.S. stock market must lead one to question those who say that markets are always efficient.

Advocates of the "efficient market theory" believe that stocks are always priced correctly, because investors immediately react to what’s known about companies. Stock prices are always about right, and it’s folly to try to beat the market, these folks believe. Therefore, it’s best just to buy index funds.

In his excellent book "The Wisdom of Crowds," James Surowiecki explains why markets typically are efficient. Anytime a large group of independently minded people are given a chance to weigh in on unknowns, the group average is usually pretty close to accurate.

That’s why when thousands of people guess how many jelly beans are in a jar, usually the group average is pretty close to right, even if there are big differences among individual opinions.

But crowds cease to be wise when all of the members stop thinking individually and start looking more at what the rest of the group thinks, Surowiecki shows.

That seems to be what is happening in the stock market these days. Investors seem to be paying more attention to what other investors think, which is leading to huge swings. Within the same trading day, markets have been moving down hundreds of points before reversing course and finishing up hundreds of points.

More than ever, this brings to mind Benjamin Graham’s analogy of his manic depressive partner "Mr. Market," who just can’t make up his mind about what your private business is worth.

This seems to be especially true during the last hour of trading, when huge swings up and down have become routine. Perhaps that has something to do with mutual funds that sometimes need to quickly sell off holdings to meet the demand for investor redemptions.

Of course there is good reason for a lot of this volatility. It seems the government announces a different strategy every day to combat the credit crisis. That leads to uncertainty over what will be the ultimate plan, making it harder to value stocks.

But most investors are probably best off not paying too much attention to the gyrations in the market, other than to use them as an opportunity to buy when prices are favorable.

Warren Buffett says that he never looks at the price of a stock until he calculates the business value of the company. He doesn’t want the price to influence his opinion of value. When the price falls far enough below the calculated value to give him a margin of safety, he buys.

And Buffett has been buying like crazy during this market turmoil–both for Berkshire Hathaway and his personal account, as he wrote this week in a New York Times op-ed piece.

Buffett wrote that the economy is terrible, but that stocks typically turn around before the economy. People who are too fearful to buy when times are tough miss out. Further, Buffett argues, cash investments may be a safe haven, but they’ll likely be hit hard by the inflationary forces of the government’s efforts to pump money into the system.

He doesn’t know when the markets will turn around, but he’s confident they will.

In the meantime, it’s probably best not to get worked up over the short-term roller coaster ride, which seems anything but "efficient."

Permalink: http://news.fredericksburg.com/businessbrowser/2008/10/19/herd-mentality-foils-market-efficiency/