Investment process
Superb businesses and Mr. Market
Sometimes it’s useful to go back to basics. When I started investing just over 50 years ago, I read that over the long-haul stocks outperform bonds. Over the years, with all the ups and downs of the stock market, I’ve never had any reason to doubt that. My default asset allocation is 100% stocks. The last time I held bonds was from 1998 to 2002 when I went almost entirely into 2-year bonds.
The other thing I read about was cycles in the economy and figured I might be able to take advantage of this in my investing. At that time, I thought the economy and stock market went in lockstep. I was wrong about that.
Beating the market
For many decades I never gave a moment’s thought to beating the market. I’m glad I didn’t. I’m convinced that trying to beat the market is a fool’s game. See my post: Thoughts on beating the market
Passive index funds appeared on the scene some 30 years ago. I think most investors are better off investing passively; and I mean passively. The returns of investors who take an active role in their equity ETFs is some 20% less than the funds they invest in. See my post The Winner’s Curse and Homo Investorus The truly passive equity investor can take full advantage of the superior performance of common stocks.
I continue to invest in a concentrated portfolio of common stocks I have chosen myself. I do it for two principal reasons. I find it stimulating. And, I seem to be able to generate excess returns over the market indexes.
I will write below about why I seem to do ok. But first, a reference to a report that inspired me to write this post.
Stock market (In)Efficiency
I just read a fifty-page report titled: Who Is On the Other Side? A Framework for Understanding Market (In)Efficiency written by Michael J. Mauboussin and Dan Callahan, CFA and published by Morgan Stanley – CONSILIENT OBSERVER – January 21, 2026.
Here is their conclusion: “We categorize market inefficiencies into four areas: behavioral, analytical, informational, and technical. The categories overlap with one another quite a bit. Behavioral inefficiencies are likely the most enduring because human nature has not changed much over time and is unlikely to change much in the future.” (Emphasis Added)
They go on to say: “To generate excess returns, investors should seek easy games where their skill will pay off. In investing as in poker, the key to winning is participating in a game where there is differential skill and you are among the most skilled players. This is a challenge because investing is generally highly competitive, markets where participant skill [differential] is low…, and agency costs commonly compel the wrong behaviors.” (Emphasis Added)
In a nutshell, the authors conclude the stock market can be inefficient and explain why. The most enduring cause is behavioral biases and cognitive errors by participants.
I agree with this assessment. What’s interesting is that the most enduring cause of investor underperformance is behavioral psychology (i.e. investor human foibles) and the most enduring cause of investor outperformance is also behavioral psychology (i.e. Mr. Market’s foibles). The most successful investors take advantage of Mr. Market and buy with a substantial margin of safety when he is in a panic; and sell to him at silly high prices when he is euphoric.
Investment process and behavioral edge
Over time I came to modify my two investment principles. I kept the idea of outperformance of stocks over the long run. I ditched the idea of cycles in the stock market and cycles in the economy. This latter cycle idea leads to market timing efforts and sector rotation, both of which are bad ideas.
My basic principles today revolve around the outperformance of stocks and buying superb companies with a Margin of Safety. See my post My take on simplicity in investing More on Margin of Safety below.
Excess returns
A few thoughts about excess returns. A professional money manager has to generate excess returns or their customers will ditch them. The problem for professional money mangers is market and return volatility. There have been periods when even Warren Buffett underperformed the S&P 500 for several years. Clients don’t like that and might drop the manager. Striving mightily to generate excess returns can be counterproductive. It’s a tough life.
Individual investors are under no such pressures. Once you understand the natural volatility of the market and investment returns, the job can be done with equanimity.
For the rest of this post, I will write about the running of a concentrated portfolio of stocks.
Superb companies and the S&P 500
Let’s compare the composition of the S&P 500 with a concentrated portfolio of carefully chosen superb companies. My portfolio contains about 15 companies. The S&P 500 contains, well, 500.
If the S&P 500 were a portfolio it would be thought hopelessly over diversified and filled with a lot of underperforming companies that would be pruned by a competent fund manager. The stocks in the S&P 500 are chosen by a McGraw Hill Financial S&P index committee based on standard criteria such as market capitalization, liquidity, public float, sector balance, financial viability and domicile. Looked at this way one would think it not too difficult to outperform such a portfolio. Of course, it is difficult.
Concentrated portfolio of superb companies
Warren Buffett describes his approach thus: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America.1998,) p.93 (Emphasis Added)
And what makes any company a superb company. Warren Buffett tells us: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” (Buffett W. E., 1998) p86 (Emphasis Added)
So that’s what’s meant by superb businesses. And yes, there is a lot of devil-in-the-details. See for example, a dozen or so of my posts: superb businesses
Margin of safety – Benjamin Graham
Given the chance to buy an ok company at a bargain price, I won’t do it. Given the chance to buy a superb company at full price (price=value) I won’t do it. The philosophy is buying superb companies with a Margin of Safety.
Chapter 20 in The Intelligent Investor by Benjamin Graham is titled “Margin of Safety” as the Central Concept of Investment’. Benjamin Graham put it this way: “In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secrets of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy – often explicitly, sometimes in a less direct fashion.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p277 (Emphasis added)
Margin of safety – Warren Buffett
Here’s what Warren Buffett says about his approach to investing: “Our equity-investing strategy remains little changed from what it was…when we said in the 1977 annual report: ‘We select our marketable equity securities in much the way we would evaluate a business for acquisition it its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and, (d) available at a very attractive price.’ We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute ‘an attractive price’ for ‘a very attractive price’.” (Buffett, 1998,) p85 (Emphasis added)
As I think of it, ‘a very attractive price’ equates with a Margin of Safety.
Buffett continues: “But how, you will ask, does one decide what’s ‘attractive’? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘’value’ and ‘growth.’ Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.”
“We view that as fuzzy thinking (in which, it must me confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?” (Buffett, 1998) p85
So, what Buffett is saying is that an investor who is not constrained by having to buy and sell stocks in a massive portfolio that may be hundreds of millions of dollars in size or even billions of dollars in size, can stick with buying only superb companies and then only at very attractive prices. That is fundamentally different than buying those companies at average or reasonable prices.
Very attractive prices are available because of the actions of Mr. Market. As Warren Buffett puts it: “At times he feels euphoric and can see only favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.” Buffett’s description of “Mr. Market” is contained in the Berkshire Hathaway’s 1987 Annual Report.
There are two main benefits in buying with a Margin of Safety. First, the estimate or assessment of fair value is very imprecise and uncertain. A Margin of Safety addresses that. Second, buying at a bargain price offers up a chance to improve one’s returns.
Active investing in 2025
I’m always alert to the possibility the world has changed and that what Ben Graham and Warren Buffett wrote years ago is obsolete. Much has changed but as Michael Mauboussin and Dan Callahan put it, the most enduring cause of investor outperformance is behavioral psychology. I have looked at other changes in the landscape, including the rise of passive investing, smart Beta and other changes. The old French adage ‘plus ca change’ remains true. See my post: Active investing in today’s investment landscape
The bottom line for me is that I don’t see any tendency caused by passive investing or algorithmic trading or retail investor trends to lead to greater stock market efficiency. The world today is filled with investors who are price insensitive. Stock market efficiency is the enemy of active investors. Stock market inefficiency is their friend and continues unabated.
Ironically, in many ways, the stock market is essentially inefficient because investors believe it is efficient; i.e. they tend to think the price is right (they are price insensitive), which is why they get things wrong. They buy without thinking about value vs price.
Comparing a concentrated portfolio with the S&P 500
A final thought about a concentrated portfolio vs the S&P 500. I’m more comfortable with a concentrated portfolio held for the long term with little buying and selling. You get to know the companies and their management. It’s relatively easy to monitor each company to see if it is still able, over an extended period, to employ large amounts of incremental capital at very high rates of return. If any company in the portfolio starts to flag in this regard it is easy to dump it and find a replacement. I did that last fall with a company I had held for over ten years.
And, if something big comes along, like AI or tariffs, you can assess fairly well what impact there will be on your holdings.
Conclusion
The path to excess returns in the stock market lies through managing one’s own behavioral foibles while at the same time taking advantage of Mr. Market’s manic-depressive behavior. Mr. Market is not only unbalanced in bubbles. He is regularly willing to buy from you at very high prices and sell to you at very low prices.
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Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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Readers wishing to dig a bit deeper into the issues discussed in this post might look at:
Do investors need to identify and invest in future FAAMGN stocks?
Owning an equal part of every business in town
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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