According to Warren Buffett, The Intelligent Investor by Benjamin Graham is “the best book about investing ever written.”
In his book, Graham proposes a thought experiment:
Imagine you own a business with a manic-depressive partner named Mr. Market. Some days, he is wildly optimistic and offers to buy your half at a high price. Other days, he is extremely pessimistic and offers to sell his half at a low price.
We generally believe you can just see anything in markets. I mean, it’s just extraordinary what happens in markets over time. It gets sorted out eventually, but we have seen companies sell for tens of billion dollars that are worthless. And at times, we have seen things sell for…literally 20% or 25% of what they were worth.
Should you accept Mr. Market’s offer? Your answer should consider 3 factors.
First, what is the true value of the business, including future prospects? To assess this, you must be an expert on the business, its competitors, and the industry.
Everybody’s got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle.
Second, how big of a discount are you getting? What is your margin of safety if something bad happens?
The 3 most important words in investing are margin of safety.
Finally, is this the best deal you’ve ever seen? Should you wait for an even better offer from Mr. Market?
When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in.
If these 3 factors align, buy as much as you can afford.
Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understood business whose earnings are virtually certain to be materially higher, 5, 10, and 20 years from now. Over time, you will find only a few companies that meet those standards—so when you see one that qualifies, you should buy a meaningful amount of stock.
Life with Mr. Market
Mr. Market’s lessons go beyond investing—they can improve your life. This includes waiting patiently for sales, and carefully choosing friends, partners, and opportunities.
If you have more than one reason to do something (choose a doctor or veterinarian, hire a gardener or an employee, marry a person, go on a trip), just don’t do it. It does not mean that one reason is better than two, just that by invoking more than one reason you are trying to convince yourself to do something. Obvious decisions (robust to error) require no more than a single reason.
A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind…And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past.
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