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How should investors make decisions? Well, intelligently. But how do we know what is an intelligent investment? Is it option A or option B? Clearly, we should choose the option that has a higher probability of bringing a greater return with the lowest amount of risk. However, the method of determining those predicted returns is where many get sidetracked.
You may have heard of Warren Buffett who is commonly referred to as “the greatest investor in our lifetime”, but you may not have heard of his mentor Benjamin Graham. Graham was the guy who taught Buffett the art of investing intelligently. In the Graham school of investing, the principles are simple: buy a business that is valued more than it is selling for. The trick isn’t in the method but in the ability to do what others aren’t doing.
Why is it that we purchase consumable goods, like food and clothing, when they go on sale, but we tend to freak out and sell businesses when the same event happens? I say business because when we purchase a stock, we are really purchasing a claim on a small percentage of the business. So why don’t we take the same approach to buying stock as we do when we wait for the Nordstrom Anniversary or Half-Yearly sale? Why aren’t we willing to wait for the right price? The majority of people buy when everyone is buying and sell when everyone is selling. This leads to major losses and creates a source of fear of investing.
Graham talked about a man named “Mr. Market”. This is the guy who offers to buy your business or sell you his, on a minute-by-minute basis. Sometimes he is extremely depressed and moody, other times he’s over excitable. Other times he’s neutral. Our job is to befriend him in such a way as to benefit from him and buy from him when he’s depressed and sell to him when he’s manic.
We can approach the purchase of stocks in two ways: 1) the psychological approach a.k.a. look at what the stock is doing or 2) the fundamental approach a.k.a. look at what the business is doing. I prefer the fundamental approach. This is the “low risk high reward” approach to investing. This is also the more conservative approach; I would rather error on the side of over conservatism than to risk complete capital losses.
When we take the fundamental approach, we look at the business rather than what we expect Joe Shmo is going to do with his ownership rights. When we come to a reasonable range of what we believe a fair value of the business is, only then do we look at the price Mr. Market is offering for it. If the price is lower than what we believe the business to be worth, than we can purchase it with confidence, knowing that the market will correct the undervaluation.
The hard part is to buy when everyone else thinks you’re out of your mind. It’s even harder to buy, without throwing up, while the price continues to decline. However, if you have a good hypothesis, with solid facts about the business, and have used good reasoning, then you can proceed with confidence in your acquisition.