Tuesday, August 23, 2011

Lesson 5: Mr. Market and Only Buy Good Companies

Mr. Market was a concept started by Benjamin Graham, mentor to Warren Buffett. Mr. Market was a way to help people see price movements in the market in a way that made sense. The idea is that you and Mr. Market are business partners. Each of you own half of a successful business. Let's use the grocery store mentioned in our previous lesson. Our grocery store has been operating for the past many years and has survived through all the recessions. The store sells the same kind of products to the same kinds of people every day, and it is unlikely for the business to change in any way in the future.

Every day, Mr Market will name a price. He is willing to buy your half of the business or he is willing to sell you his half of the business for that named price. It is your choice to make a deal with him or to ignore him. He never remembers if you have taken advantage of him or if he has done you wrong in the past. He will always
 ask you every day whether you want to buy his business or sell him yours. On most days, he is normal and in his right mind. On some says however, he gets a bit crazy. Sometimes, he has apocalyptic fears and will offer to sell you the business for a very low price, or is only will to purchase yours at a very low price. Other times, he is extraordinarily optimistic and will buy your portion for a very high price or will only to sell you his portion for a very high price. It is your choice to ignore or take advantage of him.

Let's go back to our grocery store. Regardless of how wildly Mr. Market changes the price that he names, our grocery store remains the same. It still sells the same products, sells them them to the same customers, every day. So the big question is, does the fact that Mr. Market changing the price that he named since yesterday actually change the value of our business? No! The grocery store is exactly the same as it was yesterday. If you own a good business, you need not fear when the market decides to name a lower price. You can hold your business with confidence and possibly buy more from anyone willing to give such a great deal! If your half of the grocery store gives a 3 dollar profit every single year and you paid 10 dollars for your half, you are getting a 30% return. If Mr. Market one day decides to offer you 2 dollars for it, for what reason should you sell it to him? It makes no sense!!! If anything, you should buy his portion for 2 dollars.

You lose this advantage when you buy a business without doing proper research. When you have no idea what your company is, what it does, how much money it makes, and how it runs, and most importantly, how much it is worth, you have no idea what to do when the price drops. You may have paid 10 dollars for your portion of the business. You may have grossly overpaid if the business loses 1 dollar per year. If Mr. Market decides to offer you 2 dollars for your portion, what should you do? It might not have been worth owning at 10 dollars. Can you justify that it's worth owning at 2 dollars? Could even 2 dollars be two expensive? It can be the case if you will lose all your money in 2 years by holding this company!!

The moral of this story is to only own good companies. Otherwise, you cannot find confidence to hold on when the price changes. I first started off as a proprietary trader. I was given an account to trade with, and I was allowed to take a percentage of the profits that I made. I had mentors that tried to teach us their trading strategy. The strategy had to do with looking at charts and staring at the price changes and changes in the bid/ask sizes and this was supposed to magically translate to profit. It didn't work at all for me. I'm at a point that I doubt that they were doing something profitable. Their historical success may have been due to chance, and could be that they were making less than the market return. I was in the red as soon as I started and I didn't make a dime in the 6 months that I was there. It has taken 5 years for me to unlearn all of the things that I was taught in 6 months. If you've learned things like technical analysis or enjoy looking at charts, the best thing that you can do is accept that they haven't worked, will never work, and forget all of it.

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