Mr. Market

Mr. Market is a famous allegory created by the father of value investing, Benjamin Graham, to explain the irrational and often emotional nature of the stock market. In his legendary book, The Intelligent Investor, Graham introduces Mr. Market as your hypothetical business partner in a private enterprise. This partner is a classic manic-depressive character. Every day, without fail, he shows up and offers to either buy your shares or sell you his, all at a specific price. The catch? His prices are driven entirely by his mood, swinging from wild optimism to crippling despair. He doesn't base his prices on the company's actual performance or long-term prospects, but on his emotional whims. Graham's genius was to personify the stock market's short-term volatility, transforming it from an intimidating, all-knowing force into a predictable, albeit irrational, partner whom an intelligent investor can learn to manage and even profit from.

Imagine you co-own a fantastic local business. Your partner, Mr. Market, is a bit…unstable. He is your only connection to the price of your stake in the business.

• On his good days, he is euphoric. He sees a glorious, unstoppable future. During these fits of ecstasy (what we might call a bull market), he'll offer to buy your stake for a ridiculously high price, far more than the business is actually worth.
• On his bad days, he is inconsolable. He's convinced that doom is just around the corner and the business is worthless. In these moments of panic (a bear market), he will desperately offer to sell you his stake for pennies on the dollar.

The most important part of this relationship? You are completely free to ignore him. Mr. Market has a short memory and holds no grudges. If you turn down his offer, he'll simply return tomorrow with a new one, based on his new mood. He is there to serve you, not to guide you.

The story of Mr. Market teaches the single most important lesson in value investing: Price is what you pay; value is what you get. The price Mr. Market quotes for a stock on any given day is often a poor indicator of the company's true, underlying intrinsic value. This idea stands in stark contrast to the Efficient Market Hypothesis (EMH), an academic theory suggesting that market prices always reflect all available information and are therefore “correct.” Graham, and his most famous student Warren Buffett, argue that this is demonstrably false. The daily fluctuations of the stock market are not the result of a rational machine carefully weighing new information, but the collective mood swings of millions of human participants—the whims of Mr. Market. Your job as an investor is not to guess his next mood, but to know the business's value better than he does.

You can use Mr. Market's emotional instability to your great advantage. The strategy is simple in principle, though it requires discipline in practice.

1. Step 1: Do Your Homework. Before you even listen to Mr. Market, you must have a firm, rational estimate of the company's intrinsic value. This means studying the business, its earnings power, its financial health, and its long-term prospects. You must arrive at a number that you believe the business is worth, completely independent of its current stock price.
2. Step 2: Wait for the Opportunity. Once you know what a business is worth, you can calmly assess Mr. Market's daily offers.
   • When his pessimism is at its peak and he offers you a price significantly below your calculated intrinsic value, it's a great time to buy. This gap between the low price and your high-value estimate is what Graham called the margin of safety.
   • When his euphoria is boiling over and he offers you a price far above its intrinsic value, it might be a good time to sell your shares to him.
   • If his price is reasonable and close to your valuation? You simply do nothing. Smile, politely decline, and wait for a better opportunity.

The greatest danger Mr. Market poses is not his irrationality, but his infectiousness. When he is panicking, his fear can cause you to panic and sell your wonderful businesses at foolishly low prices. When he is ecstatic, his greed can entice you into buying overpriced assets just before they crash. To succeed, you must develop the emotional fortitude to divorce your own financial decisions from the market's mood. Treat Mr. Market as a resource to be exploited, not an oracle to be followed. Use his prices when they serve you, and ignore them when they don't. If you can do that, you will find him to be the best business partner an investor could ever ask for.