The stock market is a very emotional place. Why? Because it is made up of humans beings. Fear and greed are felt and then played out, which is why you’ll see irrational bull and bear markets. Warren Buffett’s mentor, Benjamin Graham, tried to explain this phenomenon with a fictional character he called Mr. Market.
Graham used the Mr. Market metaphor to not only explain why the stock market behaves emotionally, but to discuss how investors can capitalize on these exact characteristics.
He tells the story to show exactly how stocks can become mis-priced, trading at prices that may be cheap one day and expensive the next. Investors who understand this can buy the stocks that are underpriced and sometimes sell stocks that become overpriced, to profit from the market’s madness.
Who or What is Mr. Market?
Graham described a character he called Mr. Market in his bestselling investing book, The Intelligent Investor. You are the owner of a very successful business. Say you have a man who has bipolar disorder. His name is Mr. Market.
Now because Mr. Market is bipolar, he gets really extreme mood swings. Everyday he comes up to you and offers to buy your business at a price. Some days he’ll be in a very good mood and offer you a high price for your business. Others he’ll be very depressed and offer such a low and unfair price.
All along the way, you still own a successful business. That fact doesn’t change from day to day, but the prices that Mr. Market quotes does.
You wouldn’t sell your successful business to Mr. Market at a low price just because he is in a bad mood. Maybe you would decide to sell if the price is high enough, because you understand what your business is worth and that you’re getting a good deal.
This is exactly what happens in the stock market with investors and traders. Stocks represent ownership pieces of a public corporation. A business. Wall Street quotes prices on these businesses every single day, and the price quoted can vary wildly depending on the market’s “mood”.
You can see evidence of this exactly by looking at a 1 year chart of a stock. Many financial websites quote a 52-week high and 52-week low, and the difference between the 2 figures can be quite high. Yet in a one year period, it’s very unlikely that the actual value of a business is changing that rapidly.
The business world moves much slower than Wall Street, and that’s just the nature of the market. This creates pricing discrepancies to a business’s intrinsic value.
Why does Mr. Market Behave This Way?
You might be skeptical about this metaphor by Ben Graham. After all, the market is a very large place made up of some of the smartest people on the planet. How could it make such bad pricing mistakes all the time? [continue reading…]