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Msg  4 of 8  at  5/10/2016 3:43:47 AM  by

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The following message was updated on 5/10/2016 3:46:09 AM.

Warren Buffett & Ben Graham on Mr. Market

On Mr. Market

 
 

Understanding Mr. Market's irrational and highly emotional mood swings can increase success

 
May 09, 2016
 

I previously discussed the concept of margin of safety and how it is integral to the value investing philosophy. Benjamin Graham explained this expertly in his book "The Intelligent Investor," which Warren Buffett (Trades, Portfolio) still calls "the best book on investing ever written." He further stated "chapters 8 and 20 have been the bedrock of my investing activities for more than 60 years." Since chapter 20 covered margin of safety, I figured I should also analyze chapter 8, "Mr. Market."

As always, please share your thoughts and comments below!

Talking points

  • Who is Mr. Market?
  • A succinct and clear explanation from Buffett.
  • How to use Mr. Market to your benefit.
“This imaginary person out there — Mr. Market — he’s kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed. And when he gets really enthused, you sell to him and if he gets depressed, you buy from him.” Warren Buffett (Trades, Portfolio)

Who is Mr. Market?

The investing world was first introduced to Mr. Market in Benjamin's Graham excellent book "The Intelligent Investor." Graham believed stock market fluctuations were irrational and generally based on greed and fear. He invented the hypothetical character of Mr. Market as a parable to demonstrate his philosophy, and it's simply brilliant. You see Mr. Market is an emotional fellow often displaying manic-depressive tendencies, but nonetheless he shows up, without fail, every day offering to buy and sell shares for varying prices.

http://longorshortcapital.com/mr-market.htm

http://longorshortcapital.com/mr-market.htm

Now on most days he's generally reasonable; however, Mr. Market is very temperamental and on days he's overly greedy he will offer outlandish prices compared to days he's overly fearful, when he'll offer bottom-dollar prices. Graham believed, as an intelligent investor, you should largely dismiss Mr. Market except when he is in one of his extreme optimistic or pessimistic moods. Here, Graham states, is where the intelligent investor can take advantage and buy low or sell high.

“The intelligent investor shouldn’t ignore Mr. Market entirely. Instead, you should do business with him – but only to the extent that it serves your interests.” — Benjamin Graham

A succinct and clear explanation from Warren Buffett

Who better to explain the concept than Benjamin Graham's most renowned student, Buffett? Here is an excerpt from a Letter to Shareholders found in the 1987 Berkshire Hathaway Annual Report.

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"Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. 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."

You can tell just how important and meaningful Ben Graham is and was to Buffett, as well as how instrumental the simple parable of Mr. Market has been to his success. He goes on to explain Mr. Market never gets his feelings hurt so feel free to ignore 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."

How to use Mr. Market to your benefit

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As you can tell by now, the way to use Mr. Market to your benefit is not to hinge every decision based on the irrational emotions of an unstable person (Mr. Market). Rather, learn to take advantage of him by using fundamental analysis and valuing your securities based on their intrinsic worth. Then buy or sell depending on the mood he's in. Just remember you're free to ignore Mr. Market, it won't hurt his feelings, and never seek his guidance but his wallet. Here is an excerpt from Graham's "The Intelligent Investor" that explains his philosophy very well.

"Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposed seems to you a little short of silly.

"If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price and equally happy to buy from him when his price is low. But the rest of the time you will be wise to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

https://dearmrmarket.com/category/behavioral-finance/

https://dearmrmarket.com/category/behavioral-finance/

"The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for others in his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed — this in plain English means that he is to sell his shares because the price had gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful."

Graham continues on to explain you should view Mr. Market's mood swings as favorable opportunities for you to buy and sell stock.

“Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market.” — Benjamin Graham

Summary

  • Benjamin Graham introduced the hypothetical character Mr. Market in his book "The Intelligent Investor."
  • He described him as a manic-depressive fellow who shows up every day offering to buy or sell shares at varying prices.
  • On most days he's quite reasonable but, in times of extreme optimism, he offers outlandish prices and, in times of deep pessimism, offers rock-bottom prices.
  • The great part being Mr. Market doesn't mind being ignored and will come back every day with new offers.
  • The lesson behind Graham's famous parable is intelligent investors should largely ignore stock market fluctuations except when these price swings are to your advantage.

About the author:

Chris Gilbert
I am a full-time pharmacist as well as an avid investor. I discovered the art of value investing by reading the works of Benjamin Graham. After that I began to drift towards Peter Lynch, Warren Buffett, and Charlie Munger. My investing philosophy now is simply to find great companies at a discount while using a common sense, value oriented strategy, and maintaining a long-term outlook. I am determined to educate the individual investor that investing is not hard, not time consuming, and not expensive. Through the use of value investing and the (Y)OURPORTFOLIO Spreadsheet, my goal is to help you obtain better results in a fraction of the time.

Visit Chris Gilbert's Website






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