Mr Market — Benjamin Graham on Price Prediction and Market Madness

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Mr Market — Benjamin Graham on price fluctuations, prediction, and speculation

Mr Market and other musings

In The Intelligent Investor, Benjamin Graham argues that it is “absurd” for the average investor to believe that he or she can predict prices movements better and more consistently than the market can. Average investors, after all, are by definition average. They make the market so.

As Graham reasons: 

“It is absurd to think that the general public can ever make money out of market forecasts. For who will buy when the general public, at a given signal, rushes to sell out at a profit? … There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.”

Benjamin Graham. (1973). The Intelligent Investor.

Self-fulfilling and self-defeating

Graham recalls, for example, the speculator’s enthusiasm with the Dow-theory and its charting tenets of price behavior. He suspects that it was popular in part because the theory worked for some time and “[seemed] to create its own vindication”. Indeed, traders can create a self-fulfilling prophecy when they act prescriptively and in the same direction.

But the Dow-theory and its ilk must eventually falter, Graham says. Firstly, there is “the passage of time”. Rigid formulas that appear to work today may not apply under future conditions. Secondly, there are the “self-neutralizing and self-defeating” effects of competition. Sooner or later, anything that is obviously profitable and replicable will get snatched up. You then have to ask whether such a strategy is viable when everybody is doing the same thing?

“Probably most speculators believe they have the odds in their favor when they take their chances… Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd’s, or that his adviser or system is trustworthy. But such claims are unconvincing. They rest on subjective judgment, unsupported by any body of favorable evidence or any conclusive line of reasoning. We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase.”

Benjamin Graham. (1973). The Intelligent Investor.

The elements of prudence

The prudent investor and speculator, Graham notes, must understand their: (1) own fallibility and limitations; (2) the nature of competition; (3) the many dispositions of the market; and (4) the long history of finance and economics. Such context can help the investor to see what is possible and reasonable — to minimize one’s surprise to market happenings. 

“No statement is more true and better applicable to Wall Street than the famous warning of Santayana: “Those who do not remember the past are condemned to repeat it.”

Benjamin Graham. (1973). The Intelligent Investor.

Bull markets and madness riders

Bull markets, for example, tend to exhibit several characteristics: (1) “a historically high price level”; (2) “high price [to] earnings ratios”; (3) “low dividend yields as against bond yields”; (4) “much speculation on margin”; and (5) “many offerings of new common-stock issues of poor quality”.

But one sign of its inevitable end, Graham says, is when new issues of “small and nondescript” stocks list at premiums that dwarf their larger comparators with established track-records. Prudence tends to take a backseat when the bull market rages. (But it isn’t obvious either as to when prices will self-correct.)

For this reason, Graham encourages readers to “be wary of new issues”. Participation in IPOs is not bad per se, but they require extra care for two reasons: (1) “new issues have special salesmanship behind them”; and (2) “new issues are sold under favorable market conditions”. High prices come at the buyer’s expense.

As Graham writes: 

“When the going is good and new issues are readily salable, stock offerings of no quality at all make their appearance. They quickly find buyers; their prices are often bid up enthusiastically… Wall Street takes this madness in its stride, with no overt efforts by anyone to call a halt before the inevitable collapse in prices. … When many of these minuscule but grossly inflated enterprises disappear from view, … it is all taken philosophically enough as “part of the game.” Everybody swears off such inexcusable extravagances — until next time.”

Benjamin Graham. (1973). The Intelligent Investor.

Waiting for the next crash

Indeed, among the many tenets of value investing is the belief that markets are sometimes grossly wrong and inefficient. The patient, prudent investor waits for moments of extreme, collective pessimism to find quality opportunities at bargain prices.

Graham warns, however, that it is also risky to wait only for bear markets. Fear and pessimism are often a product of uncertainty and unintended consequences. These factors, by definition, are difficult to foresee. Instead, the investor may want to look for bargains in individual stocks; and to content themselves with satisfactory returns at fair prices. 

Curiously, Graham does not oppose a “mechanical method” for saving and investing. His reasoning is behavioral: “to give [the investor] something to do”. That is, to avoid even graver mistakes by having a mild, consistent “outlet for [their] otherwise too-pent-up energies”. 

The mercurial Mr Market

What Graham is hinting at is the varied attitudes people have towards price levels and market swings. Indeed, many speculators today remain glued to the price ticker. They do not see themselves as partial owners of a business, hoping instead to profit from favorable market movements.

Similarly, some will argue that we cannot value common stocks like we would with private businesses. True, market prices will seesaw with the animal spirits of the times. Graham reminds us, however, that all a quoted market is doing is providing us with the option (not the obligation) to buy and sell at the going rate. This brings us, of course, to his famous analogy: 

“Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth … Sometimes his idea of value appears plausible and justified… Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away 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… You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

Benjamin Graham. (1973). The Intelligent Investor.

The irony of wants and prices

Markets are a funny, fickle thing. Old-fashioned investors, for example, were once more interested in income and protection than capital gains. The modern investor today, by contrast, is obsessed with growth and appreciation.

Ironically, Graham suggests that the old-timers were probably more likely to benefit from capital gains for this very distinction. After all, the modern investor that is “so concerned with anticipating the future is already paying handsomely for it in advance”.

The irony of wants and prices is a reminder that the price system is “there for [our] convenience, either to be taken advantage of or to be ignored”. Over the long run, satisfactory returns are a by-product of careful stock selection at reasonable prices. Investors that seek growth regardless of price or condition risks the very outcome they covet most.

Intelligent investors, Graham reminds, must focus on their margin of safety and shield themselves from the psychological distortion of wild market moods and the fear-of-missing-out. There’s a parallel in sports psychology that I find helpful, too — to avoid exuberance after repeated wins and despondency after protracted losses.

Sources and further reading

  • Graham, Benjamin. (1973). The Intelligent Investor: The Definitive Book on Value Investing. 4th Revised Edition.

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