FOR BEGINNERS (PART IV)

III. Markets & Psychology 


Note that I skipped Parts II (Understanding of Business) and III (Business Valuation) because I want to work on them longer.

I would break down Markets & Psychology discussion in 3 sub-sections: a) market model parables; b) market valuation and long term trend; c) psychological misjudgments.

III. a) Market Model Parables.

W. E. Buffett referred to 3 chapters essential for investing. Those are:

1. Chapter 12. The State of Long-termExpectations from “The General Theory of Employment, Interest and Money” by John Maynard Keynes: 

“Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”

2. Chapter 8. The Investor and Market Fluctuations from “The Intelligent Investor” by Benjamin Graham: 

“Let us close this section with something in the nature of a parable. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. 

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”

3. Chapter 20. Margin of Safety as the Central Concept of Investment from “The Intelligent Investor” by Benjamin Graham. 

“The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.”

A dollar is worth a dollar. When you cannot say how much a thing is worth exactly, it makes sense to be careful and pay less. The concept of margin of safety was first introduced in investing in this chapter. It was routinely used in engineering though. Bridges are designed with backup systems and extra capacity to prevent failures.

4. I would add George Soros lectures to the list. It is an interesting read, can satisfy your philosophical needs and suppress a bias to act. 

“Let me state the two cardinal principles of my conceptual framework as it applies to the financial markets. First, market prices always distort the underlying fundamentals. The degree of distortion may range from the negligible to the significant. This is in direct contradiction to the efficient market hypothesis, which maintains that market prices accurately reflect all the available information.”

 “Second, instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the so-called fundamentals they are supposed to reflect. That is the point that behavioral economics is missing. It focuses only on one half of a reflexive process: the mispricing of financial assets; it does not concern itself with the impact of the mispricing on the so-called fundamentals.”