Mr. Market

I am continuing here with Warren Buffett’s favorite 2 chapters of any book of all time. If all investors would follow these two simple concepts, trillions of dollars would have been saved in the stock market!! The two concepts explained in these chapters are the framework of Buffett’s investing methodology and are a huge part of his incredibly successful career. The two chapters are 8 and 20 of the revised edition of the Intelligent Investor, by Benjamin Graham. I will begin by explaining chapter 20, which deals with investing only when a large margin of safety.

The importance of behavioral finance and Graham’s concept of Mr. Market are some of the most difficult ideas to master in investing. Benjamin Graham strongly believed in the influence of behavioral finance on people’s long term returns in the stock market. He believed that people often lost rationality when investing because of two influences: greed and fear. In rising markets, people witness the profits that their friends and neighbors are making and become greedy and think everyone can do it. Unfortunately, many of these people buy in near the top of the market, because this is when the gains are the most obvious. Suddenly, the market turns and prices start plummeting to reflect the overvaluation of stocks in the market. However, instead of simply returning to normal levels, fear sets in and stock prices will drop substantially below their intrinsic value. Now, the investor who finally bought in near the top is reminding himself why he never should have invested in stocks, because they are too risky, and fed up with their loss of money they sell near the bottom. His fear of whatever is currently pushing the market down, whether it is a poor outlook for the economy, inflation, or deflation, causes fear which then spurs irrational selling of stocks.

Benjamin Graham noticed how fear and greed dictate people’s decisions in the market, he created a story based on the idea of a man named Mr. Market. He said that “you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels 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.

Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.””

To return to our unfortunate investors, those who let Mr. Market guide them end up always losing money, because they only buy when prices are high and sell when prices are low.Eventually these investors become convinced that they cannot make money in stocks, and curse common stock investing, instead of realizing that it was their personal strategies of investment in stocks that did not work, not investing in stocks itself. On the contrary, investing in common stocks has proven the most profitable investment vehicle in history

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