Part 8:  The Investor and Market Fluctuations

Words: 2,367  Time: 9-10 Minutes

💥 Why This Matters

• Value-Oriented Investment over Speculation: Prioritizing fundamental business value over market-driven price fluctuations

• Challenges of Market Forecasting: Timing the market is inherently unreliable for most investors; relying on these approaches can lead to speculative behavior.

• Mr. Market’s Bipolar Disorder: During periods of heightened irrationality – investors should remain calm and capitalize on longer-term opportunities.

📝 An Intro from Warren Buffett

Chapters 8 and 20 were said to make the strongest impression on Warren Buffett’s investing philosophy. Here’s a snippet from the 2008 Berkshire Hathaway shareholder letter:

Well, I will tell you what changed my own life on investing. I started investing when I was 11. I first started reading about it — I believe in reading everything in sight.

And I first started reading about it when I was probably six or seven years old.

But for about eight years I wandered around with technical analysis and doing all kinds of things, and then I read a book called “The Intelligent Investor.” 

And I did that when I was 19 down at the University of Nebraska. 

And I would say that if you absorb the lessons of “The Intelligent Investor” — particularly Chapters 8 and 20 — that you will not behave like a lemming and you may do very well compared to the lemmings.

I think it’s as great a book now as I did when I read it early, I guess, in 1950.

You will never — you can’t get a bad result if you follow the lessons of — Ben Graham taught in that book

 With that, let’s look at why this book changed Buffett’s life.

🤪 Mr. Market: A Brilliant Metaphor

This chapter centers on how investors can navigate the wild price fluctuations associated with the market.

Graham introduces the metaphor called “Mr. Market” – where it symbolizes the stock market’s irrational behavior. 

Mr. Market is known to fluctuate between extreme optimism and deep pessimism (as demonstrated in Part 3 with Marks’ market cycle)

However, most of the time the market sets prices at reasonable prices due to its volume of buyers and sellers. As Marks explains it – stocks spend the majority of the time just either side of either “not too bad” and “not terrible”.

However, sometimes, Mr. Market’s price deviates significantly from a stock’s true worth.

In these times of intense market fluctuation, investors must be cautious, recognizing Mr. Market’s tendency to overvalue stocks in bullish times; and undervalue them during downturns.

This psychological aspect is essential for intelligent investing.

It helps investors avoid impulsive decisions (i.e., self-defeating behavior) based on Mr. Market’s unstable temperament.

🎢 Cisco: What Can Happen

A striking example of Mr. Market’s irrationality was Cisco Systems (CSCO) in March 2000.

Whilst most so-called internet stocks collapsed due to not having valid business models (in many cases no revenue) – that was not the case for Cisco.

Cisco was very profitable in 2000. It reported net income of $2.67 billion with revenue of $18.93 billion. It reported net income of $2.67 billion with revenue of $18.93 billion.

Its gross profit margins were 65% – boasting a market capitalization of $550B (over $1 Trillion inflation adjusted to 2024) – making it the largest capitalized company on the S&P 500.

Apart from Warren Buffet (who warned of excessive valuations in 1999) – very few could imagine what was to come about 12 months later:

By October 2002, as the internet bubble burst, Cisco’s share price fell to $7.50 – losing ~90% of its value. 

Approximately 23 years later – Cisco has recovered a little over half its former 2000 high.

However, this is a perfect example of how sharply Mr. Market’s attitude can shift.

It highlights the potential volatility investors face when confidence turns into panic. 

Again, this can happen to the highest quality companies – not simply ultra-speculative offerings that offer very little (or no earnings). 

The takeaway here is if investor’s blindly follow market hype versus evaluating a stock’s underlying business fundamentals – these are the risks they face.

In Cisco’s case, paying 45x its revenue (not earnings) was an exceptionally high price to pay.

Trees never grow to the sky.

🤔 Thinking Independently

So how does one avoid buying a Cisco in 1999 (as I made the mistake of doing)?

Simple: think independently.

This applies not only to identifying good risk/reward trades – it applies to life.

Your ability to think critically can be the difference between a good or bad decision. It will help you avoid blind spots (e.g., believing a company that trades at 45x sales is ‘good value’)

For example, below are a handful of critical questions you might consider (not limited to):

• How do you know that? This challenges assumptions and pushes for evidence.
• Why is this important? Gets to the heart of meaning and relevance.
• What are the different perspectives on this? Encourages seeing all sides of an issue.
• What are the implications of this? Prompts thinking about consequences and outcomes.
• Can you give an example? Tests understanding and application.
• What if…? Explores possibilities and alternatives
• What is the source of this information? Evaluates credibility and bias.
• What are the strengths and weaknesses of this argument? Assesses logic and reasoning.
• What assumptions are being made? Uncovers hidden biases and perspectives.
• Is there another way to interpret this? Promotes flexible thinking.
• What is the root cause of this problem? Goes beyond surface-level issues.
• What are the possible solutions? Brainstorms options.
• What are the pros and cons of each solution? Weigh alternatives.
• What is the best course of action? Make informed decisions.
• How could we prevent this from happening again? Focuses on learning and improvement.

If you are like me and sit in as many as 8 corporate meetings per day – try a selection of these questions (or similar) and watch what happens. It will promote fact finding and/or unearth any flaws in thinking or assumptions made – without sounding aggressive.

With respect to investing – if you have the ability to ask critical questions of the market – you will likely avoid Mr. Market’s violent mood swings (and dangerous ‘group think’).

However, the average investor will allow the market’s exuberance or pessimism to dictate their actions. This will typically lead to counterproductive behaviors – which can become self defeating.

For instance, during wildly bullish markets (not unlike we find in 2024) – investors tend to invest more heavily, only to reduce their contributions when the market declines.

This behavior reflects a tendency to follow Mr. Market’s whims (herd behavior) rather than adhering to one’s independent financial objectives.

Graham advocates a rational approach where investors consider the market price as a convenience rather than a mandate.

Adopting this approach will enable you to make informed decisions that align with your individual goals and tolerance for risk.

🧑‍🎓 Mr. Market as Servant, Not Master

One of the many things I’ve learned from Charlie Munger was to always invert. 

Here are four timeless quotes:

• “Invert, always invert. Turn a situation or problem upside down. Look at it backward”
• “What happens if all our plans go wrong? Where don’t we want to go, and how do you get there?”
  
• “Instead of looking for success, make a list of how to fail instead—through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed.
• Tell me where I’m going to die, that is, so I don’t go there.”

This is precisely what we should do when thinking about Mr. Market.

Here is some very useful framing:

Intelligent investors are encouraged to view the market as a servant – who provides price options – rather than a master dictating their actions.

Mr. Market will be there knocking on your door every day offering you a price.

But guess what – you don’t have to take it.

Warren Buffett uses a baseball analogy:

“I call investing the greatest business in the world because you never have to swing.

You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you.

There’s no penalty except for missing opportunities. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”

By taking this approach with a long-term investment outlook, investors can benefit from Mr. Market’s volatility, choosing to:

• buy stocks only when they are undervalued during downturns; and
• avoid buying overpriced stocks during excessive upturns

Note: you will hear the above two points made in almost every chapter. 

The irrationality of market prices often presents unique buying opportunities for patient investors. The thing is – very few investors have patience. 

For instance, during the internet bubble, while high-tech stocks soared, “old economy” stocks, such as Buffett’s Berkshire Hathaway, were undervalued and thus represented hidden opportunities for patient investors willing to wait for Mr. Market’s eventual correction.

🧯 Ignore Market Pressure

Graham tells us that individual investor has a significant advantage over professional fund managers who must often follow Mr. Market’s trends to retain clients and maintain cash flow.

In short, fund managers are pressured to match the returns of the market (in order to justify their management fees). If they continually underperform, it’s likely you will “switch managers“.

This can put them under pressure to buy popular stocks or adhere to market indexes, regardless of the stock’s price.

For example, whilst a stock may be extremely overvalued – they are tied to Mr. Market’s prevailing mood.

For example, let’s say a red-hot stock like Nvidia (which trades more than 40x its revenue) commands more weight in the S&P 500 due to ongoing price rises. When this happens – many of these fund managers are then forced to buy more Nvidia. 

This is a terrible position to be in…

This means they don’t have the luxury of simply choosing to “wait for a fat pitch” (using Buffett’s analogy)

As an individual investor – you have that luxury.  You enjoy the freedom to hold or sell stocks without being forced to chase the market (and potentially paying excessive multiples).

Graham emphasizes this advantage, suggesting that by refusing to chase market trends, individuals can maintain control over their investments and avoid the market-driven cycles of irrational buying and selling.

😖 Overcoming Self-Defeating Behavior

More than anything else, human psychology, driven by the brain’s natural tendency to seek patterns, often leads to dangerous investing behaviors.

Investors frequently fall prey to seeing trends where none exist, leading them to make emotional decisions based on Mr. Market’s recent movements.

Neuroscience research shows that market gains release dopamine, giving investors a euphoric high that encourages overconfidence (which is self defeating).

On the other hand, losses activate fear responses, leading to panic selling.

The thing is, humans fear pain far more than the pleasure of gain (go deeper with ground-breaking research from Kahneman & Tversky on “Prospect Theory”)

In 1979, Kahneman & Tversky proved the pain of financial loss is more than twice as intense as the pleasure of an equivalent gain.

For example, if you were to make “$10,000″ on a trade – it probably feels great. However, losing $10,000 delivers a blow which is twice as powerful.

I had this experience in 2000. The prospect of losing (more) money was so painful – I feared losing everything – selling near the bottom.  What’s more, in the subsequent 12 months, I could not psychologically pull the trigger to buy bargain quality stocks.

What’s more, this is hyped by financial media outlets.

For example, the headlines will read “Dow Jones plunges 5%” with some image of a large growling red bear.

However, how often do you hear the headline “the Dow is up 30% over the past two years – therefore a 5% decline is neither here nor there.”

Why? Fear sells.

This kind of feedback only reinforces the pain of losses is felt more acutely than the pleasure of gains.

Psychology makes it more challenging from most investors to stay the course during downturns. However, by simply understanding these psychological responses – it will help you avoid the traps of making emotionally charged decisions.

🐢 The Tortoise Wins the Race

Taking a long-term investment approach dramatically increases your probabilities of making a profitable investment.

However, because timing the market is difficult, Graham advocates that by regularly investing over time, investors can ignore short-term fluctuations and capitalize on lower prices in bear markets.

This consistent, patient approach minimizes impulsive reactions to Mr. Market’s (manic) mood swings and encourages the growth of a diversified portfolio (for example, buying an Index fund).

He recommends investors adopt a strategy of dollar-cost averaging, where they invest a fixed amount regularly, regardless of market conditions.

This approach protects investors from the risks associated with trying to time the market, helping them stay focused on their financial goals

🏆 Measuring Success 

According to Graham, successful investing is not about “beating the market” or outperforming others. In his view – it’s about achieving personal financial goals.

For example, many people feel pressured to compare their returns to market indexes – however you shouldn’t. 

From Graham’s lens, the ultimate goal of investing is to meet individual needs, not to compete.

For example, for some people who return 6% per year is more than enough to comfortably meet their annual needs. However, for others, this figure could be as high as 10%. 

This figure is a function of what you need to give you financial security. 

Personal financial planning, disciplined investing, and sticking to long-term objectives are key to attaining financial security.

Investors should focus on building a portfolio that aligns with their lifestyle and future goals – rather than obsessing over short-term fluctuations in market performance.

 4 Key Takeaways

• Graham’s investment philosophy urges investors to remain calm amid Mr. Market’s extreme behaviors

• Investors should never feel pressured to buy – and instead should make the market their servant (vs their master)

• Focus on controlling their own actions rather than attempting to outsmart the market. 

• Qualities such as patience, independent thinking, and adherence to long-term goals, investors can leverage Mr. Market’s (constant) irrationality to their advantage, securing their financial well-being without falling victim to the market’s unpredictable nature