Investing is hard. To be able to outperform the market consistently, you need to be able to predict the future. Unfortunately, predicting the future is impossible.
So, investing is a game of probabilities. Estimating the probabilities of individual outcomes and then investing in the scenario with the highest likelihood of success. As it is impossible to predict the future, it is best to include a wide margin of safety in the calculation of the probabilities.
First proposed by Benjamin Graham, who has come to be known as the Godfather of value investing, nearly 100 years ago, the margin of safety is a concept designed with one primary goal in mind; to reduce risk.
Reducing risk should be an investor’s primary objective, but this is often overlooked in favour of reward. To put it another way, too many investors spend far too much time trying to analyse how much money they could make, rather than assessing how much they could potentially lose.
And this is why so many investors, both private and institutional, fail at investing according to Seth Klarman, one of the most respected figures in the world of value investing today.
Klarman’s whole strategy is based around the idea of not losing money, which he described at the MIT Sloan Investment Management Club on Oct. 20, 2007:
“Right at the core, the mainstream has it backwards. Warren Buffett often quips that the first rule of investing is not to lose money, and the second rule is not to forget the first rule. Yet few investors approach the world with such a strict standard of risk avoidance.”
“For 25 years, my firm has strived not to lose money — successfully for 24 of those 25 years– and, by invest and cautiously and not losing, ample returns have been generated. Had we strived to generate high returns, I am certain that we would have allowed excessive risk into the portfolio– and with risk comes losses. Some investors target specific returns. A pension fund, for example, my target an 8% annual gain. But if the blend of asset classes under consideration fails to offer that expected result, they can only lower the goal– which foremost is a non-starter– or invest in something riskier than they would like.”
“The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk.”
As Klarman sees it, when it comes to assessing investments, investors are concentrating on the wrong side of the risk/reward equation. Worse still, when markets fall apart, investors are not prepared enough to deal with the ensuing turbulence:
“Many investors lack a strategy that equips them to deal with a rise in volatility and declining markets. Momentum investors become lost when the momentum wanes. Growth investors — who pay a premium for the fastest growing companies — do not know what to do when the expected growth fails to materialise. Highly leveraged investors… are forced to sell…
By the time the market drops and bad news is on the front pages, it is usually too late for investors to react. It is crucial to have a strategy in place before problems hit, precisely because no one can accurately predict the future direction of the stock market or economy. “
What’s Klarman’s solution to this dilemma? He believes value investing offers the best option:
“Buying stocks at an appreciable discount from the value of the underlying business is one strategy that provides a roadmap to successfully navigate not only through good times but also the turmoil. Buying at a discount creates a margin of safety for the investor — room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies.”
There are only two factors investors can control at all times, timing and costs. Keeping costs as low as possible is relatively simple, but marketing timing is much harder. It’s more than likely that investors will mistime the market 100% of the time.
There’s not much you can do about this. However, you can tilt the odds of investing success in your favour if you make sure you invest with a wide margin of safety to allow plenty of room for manoeuvre if things don’t go to plan.
And if you approach the investment process with a strict standard of risk avoidance, you should be able to avoid ever having to deal with the worst case, 100% loss scenario, which can set you back years.