Benjamin Graham’s Famous Allegory: Introducing Mr. Market

Investing Wizard Benjamin Graham introduced the famous allegory of “Mr. Market” in The Intelligent Investor to demonstrate how the unreliability of market emotions can help contrarian investors:

Imagine you’re business partners with a very unstable guy called Mr. Market. Your business is worth around $1000 per share. Every day, Mr. Market offers a price to buy your shares or sell his shares of the business. Sometimes, Mr. Market is in a great mood and offers to buy your shares at a price way higher than what the business is worth, let’s say $2000. Other times, Mr. Market feels depressed and offers to sell his shares at a super low price – $500. You get to decide whether you want to buy, sell, or do nothing.

How would you want to trade with Mr. Market? It’s obvious that you would buy the business when Mr. Market offers it at the low price of $500 and sell your shares when Mr. Market is willing to pay $2000. Well, the stock market is Mr. Market (or any other market, such as real estate, commodities, etc.)!

Optimism and pessimism can drive the market valuations too high or too low, depending on investors’ outlook. The broader market’s valuation can often drop more than 50% before starting a new bull phase market. BUT market mis-pricing does not only happen during financial crises; individual investments can often be mis-priced in normal times too. Here we’ll use Apple, a popular stock today, to explain price fluctuations in the market.

As of September 1st, 2020, Apple had a $2 trillion market capitalization making it the most valuable company in the world. Apple stock in the first eight months of 2020 went from $300 to $220 to $460. How did the value of Apple increase by over one trillion dollars when its business operations did not go through significant changes? Did Apple’s business shrink, then double, in reality? While Apple still sells a lot of iPhones, there is nothing truly ground-breaking in the business plan that shocked investors. The answer:

Price (Perceived Value) ≠ Value

While business operations likely don’t change from day to day, the market perception of a business’ prospects can be hijacked by market emotions and irrationality, providing investment opportunities. At the peak and bottom of cycles, our unstable partner Mr. Market is subject to extreme emotions – greed and fear. If you know the market will be irrational at times (and it certainly will be), you can trade as you would with Mr. Market—buy low and sell high! 

This quote from Wizard Warren Buffett serves as an excellent conclusion: “Be fearful when others are greedy, and greedy when others are fearful.” Greed and fear often drive the price above and below the fair price. Ultimately, by staying calm and objective, you can take advantage of these emotion driven (long-term) cycles.