Sunday, August 9, 2009

Margin of Safety

So, how exactly do we implement Buffet's Two Rules of Investing. This brings us to another important concept of value investing called "margin of safety". I am quoting from Chapter 6 of the book "Margin Of Safety" by Seth Klarman:

Benjamin Graham understood that an asset or business worth $1 today may be worth 75 cents or $1.25 in the near future. He also understood that he might be wrong about today's value. Therefore Graham had no interest in paying $1 for $1 of value. There was no advantage in doing so, and losses could result. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.

Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error (of estimation of value), bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world. According to Graham, "The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some higher price."

Buffet described the margin of safety concept in terms of tolerances: "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing."

Most investors do not seek a margin of safety in their holdings. Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve margin of safety. Greedy individual investors who follow market trends and fads are in the same boat. The only margin investors who purchase Wall Street underwritings or financial-market innovations usually experience is the margin of peril

Buffet, in his 1990 letter to shareholders, says the following:

In the final chapter of the book The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: "Contronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Forty-two years after reading that, I still think those are the right words. The failure of investors to heed this simple message caused them staggering losses ...

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