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Warren Buffett, Mr. Market and the Secret to Investing Success


Every so often, I find it valuable to go and read some of Warren Buffett (Trades, Portfolio) and Benjamin Graham's historical advice about the volatility of the market.

I do this because it is very easy to get caught up in market euphoria and forget that stocks go up and down all the time. In an attempt to remind myself that it is always best to focus on the fundamentals and ignore share price movements, I like to revisit the sage advice of these two renowned gurus.

Mr. Market

Possibly their most famous advice is the concept of Mr. Market, a character created by Graham in his first book, "The Intelligent Investor." Graham created the character to explain how volatile the market can be and why investors should never make trading decisions based on stock price movements.

At the 2012 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting, Buffett proclaimed that chapters eight and 20 of "The Intelligent Investor," where Graham first introduced Mr. Market, are "all you need to do to get rich in this world."

He went on to explain the idea behind Mr. Market:

"Chapter eight says that in the market you're going to have a partner named 'Mr. Market,' and the beauty of him as your partner is that he's kind of a psychotic drunk and he will do very weird things over time and your job is to remember that he's there to serve you and not to advise you.

And if you can keep that mental state, then all those thousands of prices that Mr. Market is offering you every day on every major business in the world, practically, that he is making lots of mistakes, and he makes them for all kinds of weird reasons. And all you have to do is occasionally oblige him when he offers to either buy or sell from you at the same price on any given day, any given security."

The key to good investing

The principle behind Mr. Market is simple, but applying this to your investing strategy is not so easy. It is challenging to sit by and watch stock prices fly higher in a bull market without trying to get in on the action.

Similarly, it's even harder to watch your money vanish as stock prices fall. Studies have shown that humans feel financial losses more than monetary gains.

The key is, as Buffett went on to explain, to concentrate on the underlying fundamental value of every business. "The important thing is that you make your decisions based on what you think the business is worth," he said. If you stick with businesses that you know how to value and make buy and sell decisions based on what you think the business is worth, "you simply have to do well in stocks."

Since the stock market is an auction market open seven hours every day and driven mostly by emotional trading, buying undervalued businesses is easy for investors who are willing to sit on their hands and make the most of the irrational market. Compared to other investment alternatives, the stock market is a fabulous market to invest with, Buffett went on to explain, because Mr. Market is so irrational:

"If you own a farm and the guy has the farm next to you, and you'd kind of like to buy him out or something, he's not going to name a price every day at which he'll buy your farm or sell you his farm, but you can do that with Berkshire Hathaway or IBM."

According to Buffett, if you know and understand why this is the case, and how you can play it in your favor, you are sure to do well in the stock market over the long term.

"It's a marvelous game. The rules are stacked in your favor if you don't turn those rules upside down and start behaving like the drunken psychotic instead of the guy that's there to take advantage of it."

Disclosure: The author owns shares of Berkshire Hathaway.

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This article first appeared on GuruFocus.