Monday, January 10, 2011

Say Hello to Mr. Market

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

First, let me apologize for any inconvenience you may have experienced by my missing last Monday's post.  I was out of town for the Christmas Holiday and goofed up the "timed" post publishing feature on the blog site.  I published it as soon as I realized this on Wednesday.  That post received a comment from Sam, one of our readers.  You can click his comment and my reply at the bottom of the January 5th post.  As I told him, he had anticipated this post.  Dr. Le Bon showed how any investor, including Sam's cynic, can be affected by the irrationality of the market, but only if the investor lets the market crowd sway his investment convictions.  The way to avoid these external influences is to think of the market in the terms used by Benjamin Graham in his seminal book on investing, The Intelligent Investor.  Mr. Graham, who taught Warren Buffett at Columbia University, described the market as follows: 

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 proposes 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 wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

And, as they say, no one has ever said it any better.

There are two things to take away from Mr. Graham's analysis of Mr. Market.  First, the quotes made by the market for stock are transitory - the quote is only the stock's price at that moment.  And that is a price you can choose to accept or ignore at that moment.  Like buses, there will be another one along in a few minutes.  Second, the individual investor should always keep in mind what he or she believes the value of the stock to be when that momentary price is presented and not confuse price with value.

The price of a stock at any given moment usually has no relation to the value of the business represented by the stock.  If Mr. Market's offer to buy is at a price which, in your estimation of true value, is foolishly inflated, you can sell and pocket the money.  Conversely, if his offer to sell is at a price which, in your estimation of true value, is ludicrously low, you can buy from him.  Then just wait for his subsequent buy bid to exceed the price he previously sold it for by an amount you find attractive.  Then sell it back to him.  Continue to repeat this process.  All an investor has to do is wait for Mr. Market to turn irrationally happy or sad over and over again.  If his quote seems sane and close to value, well just walk away and do nothing.  There is no obligation to sell on your part.

If you personify those millions of individuals involved in the stock market every day as just one person, Mr. Market, it makes it easier to decide whether you buy, sell or ignore his price completely.  That will significantly reduce the external pressures exerted by the crowd.  If you assume Mr. Market is usually nuts, then it's easy to ignore him.  If he happens to be right, you can nod your head in agreement and go for a walk.

Sam also asked about the internal pressures discussed by Mr. Mamis.  We will discuss how to deal with them in the next post.

Like Sam, you can leave a comment without going through the process of signing in.  Click the comments link, add your comment and pick the "Anonymous" profile.  Add your name if you wish.  Your comment will be posted within 24 hours of receipt.  Sam and I would enjoy hearing from you.

The Intelligent Investor - Revised Edition by Benjamin Graham, copyright 1973, is published by HarperCollins Publishers, Inc. in their HarperBusiness Essentials series. 

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