Sunday, 13 January 2013

The godfather of value investing

Benjamin Graham is considered by most to be the founder of value investing and was Warren Buffett’s mentor as he was forming his investment philosophy. Buffett carefully studied Graham’s books and even attended his class at university.

Benjamin Graham liked to demonstrate the core of value investing and the craziness of financial markets by the example of “Mr. Market”. Depending on who you ask, they might tell the story a bit differently, but in all cases the underlying lesson of the analogy is the same:

Imagine a fellow, let’s call him Mr. Market, who turns up at your door every day and wants to sell you some shares of a company for a price. You can either agree to buy those shares or turn him down. In any case, you know that he will be back tomorrow attempting to sell you the same shares. Now, add to the equation, that Mr. Market is emotionally unstable. Thus he might be very optimistic today and quote a high price only to wake up depressed the next morning and thus quote a much lower price.

The lesson of this analogy is that financial markets are irrational. Investors should take advantage of this and subsequently buy shares when they are under-valued and vice versa. This obviously is highly counter intuitive, as people by nature want to fit into a group and thus let themselves be carried away by the euphoria and fears of others.

Benjamin Graham authored “The intelligent investor”. A book so important, that it is often referred to as the “bible of value investing”. Warren Buffett characterizes it as “by far the best book on investing ever written”. Anyone seeking to become a true value investor, should study this book.

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