Focus on Finance
Mr. Market 4.0 The Evolution of Market Trading
By George Morgan
In his 1987 Berkshire Hathaway Annual Report, Warren Buffett introduced the concept of Mr. Market. Mr. Market is a tongue-in-cheek recognition of the fact that, most of the time, the stock market’s actions are based on arbitrary random activity rather than rational, calculated reasoning. In Warren Buffett’s own words,“following formulas and analysts’ market predictions is a waste of time. Mr. Market will tell you what you need to know.”
The purpose of a market is to bring buyers and sellers together to negotiate a price. A market needs two parts in order to function. It begins with the market participants— that is, the buyers and the sellers. These participants can be persons, institutions, companies, or machines. The second part of a market is an exchange, which brings the buyers and sellers together, negotiates a price, and then disseminates that information to the public. A market exchange can be a person, place, or thing. I first met Mr. Market 1.0 when I became a stockbroker in 1980. This is how the 1.0 version worked: I called a client and advised buying 100 shares of XYZ. I then called our trading desk with this information. The trading desk called our guy in Chicago, who called his guy on the floor of the New York Stock Exchange (NYSE). The guy in New York wrote the order in a book and looked for someone who was selling 100 shares of XYZ. When he found a seller, he called our guy in Chicago with the price. Our guy in Chicago called our trading desk, and then they called me. When the time came to sell the shares of XYZ, I set the process in motion again. During this time, events were already occurring that would alter the process and morph Mr. Market 1.0 into Mr. Market 2.0. It started in 1976, when Jack Bogle invented the index fund. Index funds track a market index in a passive fashion. They buy and hold all the stocks in an index, in the same ratio that they appear in the index they mimic. This offers investors an alternative to choosing individual stocks. While Jack Bogle was doing his thing, Joe Ricketts formed a company whose mission was to allow the individual investors to circumvent the cumbersome Mr. Market 1.0 process I outlined above. He developed technology and a system that allowed individuals to purchase investments on their computers and, eventually, on their cell phones. The next big change came when the U.S. Securities and Exchange Commission (SEC) decided that the NYSE needed more competition. Within the blink of an eye, 16 new exchanges sprang up. None of them looked like the NYSE. There were no humans in blue lab coats with phones plastered to their ears…just cavernous rooms housing computer servers with flashing lights and a gentle whirring sound. Each new exchange created its own prices, and those prices were transmitted to a central 42
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computer at the NYSE that reconciled them and published a single composite price. Within months of the new exchanges coming online, Mr. Market 3.0 emerged. Private firms launched their own programs to access each of the new exchanges directly rather than having to connect with them through the NYSE. The goal of the private firms was to build state-of-the-art computer systems that would trade at the prices of the individual exchanges before they were transmitted to the NYSE and bundled into a single price. This allowed them to buy stock on one exchange and then sell it, a fraction of a second later, at a higher price on a different exchange. They could also make money in the reverse scenario, by selling stock shares that they had purchased a fraction of a second earlier in another exchange at a lower price. Fast-forward to today and say hello to Mr. Market 4.0, with its 17 electronic exchanges on one side of the equation and the hundreds of computers run by professional traders on the other. On an average day, as many as six billion trades are transacted. That translates to 20,000 trades for every man, woman, and child in America. The outcome of this flurry of activity is that prices are determined by who has the biggest and fastest computer and who makes the most trades. In the short run, Mr. Market 4.0’s daily activity results in prices that are random and unpredictable. This creates both challenges and opportunities for individual investors. In the long run, investors with patience and a willingness to explore index fund investing can produce an acceptable and rewarding return. As always, my caveat is that one size does not fit all. Editor’s Note: Professor Morgan has over 40 years’ experience in the investment field, both as a university professor and as a financial advisor. He currently serves on the faculty at the University of Nebraska at Omaha, where he directs a program designed to educate 401(k) plan participants on how to improve their investment strategy. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing.
