Benjamin Graham explored the concept of the stock market and an investor’s analysis decision through the use of an imaginary investor named Mr. Market. The basic principle underlying the theory is that a rational investor would base his opinion on the fundamental value associated with the stock rather than the view of fellow investors or the signals sent by the stock market. The view is based on the principle that an investor must act rationally at all times and the decision made must be based on the intrinsic value associated with the stock rather than the market fluctuations which might sometimes send out the wrong signals.
So what exactly is the Mr. Market parable proposed by Benjamin Graham? The story goes something like this: you must assume that you own a small number of shares in a private business that resulted in a total cost of $1000. A close associate of yours, namely Mr. Market is quite interested in your stock holdings and on a daily basis he expresses his opinion regarding the value of the shares. He is more than willing to buy the shares on some occasions and on other he is willing to sell his share to you at a quoted price. The price estimated by Mr. Market is sometimes a reflection of the true value of shares based on business developments and future prospects. Conversely, sometimes his estimates are not justified and seem a bit over exaggerated. You are not under any obligation to listen to Mr. Market and his advice. He does not mind providing advice on a regular basis irrespective of your opinion and attitude.
So what exactly should a prudent investor do in the case of Mr. Market and his price estimates? Should a person be influenced by the price quotations and buy or sell the stock based on Mr. Market’s estimates? Well this is only beneficial for an investor when Mr. Market quotes a price that is very high and therefore an investor sells the stock with the aim of making a huge profit. An investor is also likely to follow Mr. Market’s advice when the price quoted is very low and therefore buying shares at a low price would result in a foreseeable profit when these are sold at a higher market price. However, these two extreme scenarios are the only occasion when an investor would be compelled to buy or sell stock. In all other circumstances a person is likely base his judgments on true facts and figures derived from a company’s financial position and future outlook.
The Mr. Market in reality is none other than the stock market that daily shows a change in price of shares. An investor that owns stock in a listed stock exchange is likely to be faced with the dilemma of changing prices almost on a daily basis. Either the price can be used to make a profit such as selling when price is too high and buying when price is too low, or the market price can be left alone. An investor must realize the importance of his own judgment in making investor decisions. The signals emitted by the market might sometimes be misleading and this could indeed result in a loss to the investor.
How can the market price be misleading? Well the stock price is dependent on a number of factors and amongst them the greatest one is speculation. Speculation of investors can result in an extremely high price for example if the company is likely to acquire another company, the hype in the market could create a rise in stock price. However, this price is not an indication of future prospects of the company or the ability to generate profit. An investor that sells now simply due to high price might at present face a profit but in the long term could be at a loss as the opportunity cost of selling is the long stream of dividends that follow the investment in the future.
Conversely, a person may simply sell the stock if the prices has gone down in the view the decreasing prices have a signaling effect that things within the company are getting worse. However this is reality might not be true. The price could simply be decreasing because no dividends have been declared for the given year as the company is now implementing a reinvesting policy. Thus the decrease in price might send a wrong signal to the investor who could sell the shares and lose out on dividends and capital gains in the future.
The Mr. Market analysis theme is simple and effective. The market price results in fluctuations and an investor must not solely base his decision on the price fluctuations. A prudent investor must consider other facts before buying or selling stock and this includes the current operating position of the company and the future developments. An investor must ascertain the dividend income in the future as opposed to capital gains at present and then undertake a decision.
This does not mean that the market price is irrelevant. The market fluctuations must not be ignored by an investor as they provide a signal of the value of the investment. However the true significance of market price lies in the opportunity that it provides by depicting a price too high or too low, The market price is of great importance and profitability when it depicts an extremely high price as huge capital gains could be made from sales whereas an extremely low price could result in stock purchasing so that they could be sold at a higher price in future.