An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.' This was how Benjamin Graham defined 'investment'. And rightly so.
In these times, when the markets are witnessing high volatility, it is imperative for stock buyers to understand this difference between a speculative activity and investment. It requires just a misguided step for the investor to turn his investment venture into a speculative misadventure.
In this regard, Graham's parable of 'Mr Market' stands in good stead. This is, probably, one of the best metaphors ever created for explaining how stocks can become mispriced.
Through this parable, Graham asks investors to imagine a non-existing person called Mr. Market who is your (investor's) partner in a private business. He appears daily and names a price (stock quotation) at which he would either buy your interest or sell you his. Now, despite the fact that, both, Mr Market and you have stable business interests, his quotations are rarely so.
At times, he falls so ecstatic that he sees only the favourable factors affecting business. And this is the time he would name a very high buy-sell price because he fears that if he does not quote such a high price, you would buy his interest in the enterprise and rob him of imminent gains.
And then there are times when this very Mr Market is so depressed that he sees nothing but trouble ahead for both business and the world. These are the occasions when he would name a very low price, as he is terrified that if he does not do so, you would burden him (sell him) with your interest in the business.
Now, Graham says that if you were a prudent investor or a sensible businessman, you would not let Mr Market's daily communication determine your view of the value of your interest in the enterprise. 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.
For the rest of the time, you would 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.
What Graham tells investors through this parable of Mr Market is that they should look at market fluctuations in terms of the Mr Market example. They should make these fluctuations as their friend rather then their enemy. This means that they should neither give in to temptations that rising markets bring with them nor should they think of doom when the markets are falling incessantly.
Coming back to the abovementioned definition of an investment operation, investors need to have a long-term (two to three years) perspective when making their investment decision. Only then would the promised safety of principal and an adequate return accrue to them.
Now, the term 'adequate return' typically varies from investor to investor. A high-risk investor would demand a high return from his investment from the extra bit of risk he is taking. On the other hand, a low-risk investor would settle for a relatively lower return.
Having said that, in a rising market, expectations tend to be on the higher side without a fundamental premise. Here is where Mr Market could mislead you. If you believe that 15 per cent per annum is an 'adequate return', then stick to that irrespective of whether it is a bull market or a bear market. Otherwise, you are changing, i.e. risk profile is changing, which is not required.
As Graham says, '. . .in the short term, the market is a 'voting' machine whereon countless individuals register choices that are product partly of reason and partly of emotion. However, in the long-term, the market is a 'weighing' machine on which the value of each issue (business) is recorded by an exact and impersonal mechanism.' Happy investing!