An investor’s Philosophy will be deeply influenced by how they view, interpret, and interact with the stock market aka “Mr Market”. Before investors start creating an investment philosophy and strategy, they need to consider the two terms below. These concepts refer to the “belief” component when discussing and developing a strategy. Your views and alignment around whether they exist or not will largely shape your investing experience and how much involvement you will have in the process.

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How you respond to these two questions will guide everything you do moving forward as an investor. We will explain each of the two terms further in. In the meantime, here is how you can start to form a belief about the stock market and where you may fit in.

Do you believe the Stock Market is truly efficient?

If you answered Yes and believe the stock market is truly efficient, then it makes little sense to pursue being an active stock picker. You may be better suited to being a passive investor perhaps in an index fund. The theory behind this is if you can not beat the average, join them. That is not a bad idea, you can still reap the long-term compounding of global markets and so you should.

However, if you answered No, and you believe that inefficiencies exist in the stock market, then go through the next sequence of questions. Why do you think they are inefficient? Where do you think you can gain Alpha from taking advantage of market inefficiencies?

What is your belief around the idea of “Mr Market”?

Do you understand how “Mr Market” is made up and believe the ideologies behind it? This includes mood swings, volatility, the behavioural and psychological impacts on the market, and the cycles. Do you agree that the stock market, short-term and long-term each pose different outcomes?

Mr Market is a great explanation of the Stock Market.

The term Mr Market was the brainchild of Benjamin Graham in his book, The Intelligent Investor. He explains how Mr Market is this irrational hypothetical investor, driven by emotions, panic, and euphoria. He approaches investing based on his mood (Market Mood Swings) rather than fundamental and rational decision-making. The idea explains perfectly well the groupthink and the wild fluctuations from optimism to pessimism that the market experiences.

The concept was to help investors understand that they can approach the markets in 2 ways. The first is an irrational, manic depressive, following the crowd and being driven by emotions. The second is to approach investing with rational decisions based on fundamentals and logic.

Mr Market is always willing to buy and sell a stock, at any given day and time. Based purely on the rise and fall of the stock (think 52-week high and low ranges). These are all based on emotions, and mood swings of the market that cause such a dislocation of price. Due to the behaviour of Mr Market, this inefficiency can give the diligent investor many opportunities to enter and exit and take advantage of these mood swings.

Think about some of the biggest companies that exist. Look at the disparity in the 52-week high and low ranges. These fluctuations can push stocks under or overvalued. Mr Market is not saying that markets are always inefficient, they generally run efficiently, until they don’t.

Explaining the Stock Market over the short and long term.

Benjamin Graham also explained the stock market perfectly with his famous quote. “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

The Stock Market Short-Term is a voting machine.

This refers to the short-term noise of the markets that cause such wild fluctuations that often have nothing to do with the underlying business fundamentals.

• Analyst calls, such as missing earnings on forecasted numbers.
• Market votes on the popular companies, story stocks, what’s hot.
• Short-termism, shorter holding periods, impatience.
• Indexing and rebalancing based on market caps, industry, and not fundamentals.
• Hyper traders in today’s markets and algorithmic trading.
• Financial Media, noise, pumping doom and gloom.
• Herd mentality, shareholder offloads, they all offload.

The Stock Market Long-term is a weighing machine.

This refers to the long-term idea that the stock market over time becomes a weighing machine based on finding and holding the winners. It assesses the intrinsic value of a company based on its earnings power and the quality of its assets.

• Fundamentals of the business, the quality.
• The value of the company.
• The company’s competitive advantage.
• Growth runways ahead.
• Mispricing due to short-term Mr Market creating bargains.
• Patience and investor discipline and awareness.

What is the Market Efficient Hypothesis?

The efficient market hypothesis suggests that the market cannot be beaten because all the important information is built into the current share prices. This suggests that stocks trade at their fair value all the time. There are 3 segments of the efficient market hypothesis which brings into consideration whether the market is efficient all the time. The three versions of theory are weak form, semi-strong, and strong form.

Weak form suggests that the current stock price (today) reflects all past data of prices so no technical analysis can help investors.

Semi-strong form suggests that because public information is built into the stock price, investors can’t use technical or fundamental analysis. They need information that isn’t public to benefit.

The strong form theory suggests that all the information whether public or private has been fully built into the stock price and there is no advantage or edge an investor can gain.

There are a lot of areas that the efficient market theory cannot account for. If it were entirely true and markets were not efficient, you wouldn’t have investors beating them year in and year out.

While I believe there are many inefficient areas to take advantage of, the market, especially large caps, can be efficient. With so many analysts covering big companies and funds trading in and out, there is little information that is not widely known and therefore built into the price. That is why I venture into the Mid-Caps and Small-Caps because the inefficiencies are everywhere with less information built in.

An example of Mr Market and EMT playing together.

Let’s look at a recent example of Mr Market and the Efficient Market Hypothesis in action. In 2022 a combination of factors contributed to Tech stocks falling more than 30%. The decline came due to higher interest rates, high inflation, and uncertain economic conditions that pushed nervous shareholders out of growth stocks looking for safety.

In this example, we have the FAANG stocks all trading at high valuations, with the assumption of fair value. Mr Market came along and with his emotions caused a little chaos and panic resulting in a very fast sell-off.

Prudent investors knew the underlying fundamentals had not changed, not to the effect of a 30% sell-off anyway. It was an opportune buying moment to pick up quality companies which only a few months later were once again trading at all-time highs. That is Mr Market and the “efficient” market in full swing for you.

In Summary…

In this article, I aim to give investors a general idea of what building a belief around markets means. I purposely avoided going too deep into EMT (as I am not a follower of this) as it can be confusing for investors.

I believe that studying the Mr Market concept can help investors form their views of the market, which is incredibly important. If you believe that markets have inefficiencies and you see how Mr Market can create opportunities for you, then this can help you form a strategy that governs where you want to start looking.

For example, I prefer looking for rising stars and high-quality companies that are too small to cover yet, but still present inefficient entry points. These companies can become efficient one day, long after I’ve invested in them!

My Philosophy and belief around markets is the further up the Market Cap range you go, the more efficient the market becomes. The inefficient buying opportunities at the top end are often the result of Systematic risk which creates pessimistic market sentiment. As private investors, we can not gain any advantage over fund managers, or analysts on Wall Street who all move a lot faster to accessible information than us.

At the lower end, an informational advantage can be created by “Investigate Journalism”, going to lengths other investors are not. I have found and taken advantage of many inefficiencies in the market, so I believe they exist.