MARGIN OF SAFETY
MARGIN OF SAFETY
Markets can remain irrational longer than we can remain solvent.
MARGIN OF SAFETY
MARGIN OF SAFETY
When we invest, we expect a return on our money. Over a period of time, be it three years or five years or more, we expect returns that are higher than simply putting the cash in a bank savings account.
As explained previously, this means taking some risks. Risk-free return from a bank account will always be lower than sensibly invested money. It has been proven many times – a read of the Barclays Capital Equity Gilt Study (Page 95, Figure 13) and we can see the numbers backing it up.
However, we must be careful that we are not confusing the term “investment” with trading or speculation.
REDUCING RISK
There is a great book by Seth Klarman called Margin of Safety. In the book, the author tells us that art, gold, silver, stamps, coins are not really investments. They are speculative assets that over time may increase in value (or may not!). So that when the time comes to sell, we can only hope that we find someone who is willing to pay a bit more money for them.
With our own investments, we must always ensure that we have a certain margin of safety.
It means that we must not speculate in individual stocks or shares. Shares are volatile and we could lose most or all of our investment very quickly. We must also be careful before investing in crypto-assets that are highly specialised, highly speculative and highly risky instruments. Most of us have heard about Ruja Ignatova and ONECoin. If not, read the story below.
Investments should never be exciting – if it is, we should think carefully whether we are investing or speculating.
A BASKET OF SHARES
The best margin of safety is when we invest in not one but a basket of shares that follows a market index. This is known as diversification or indexing. It is generally considered to be a boring but safer form of investing. Our returns will never beat the market but on the other hand it will never under-perform the market either.
Another form is called active investing where a fund manager would choose a bunch of shares and then create a fund. These are called active funds and their sole purpose is to generate returns that try and beat the market or a benchmark.
We should be aware of this form of investing.
It is very difficult to beat the market consistently and often investors lose large chunks of their investments when the fund fails to perform as per expectation. They are costlier than index funds and the successful ones are also extremely difficult to spot in advance.
For most retail investors, the best strategy is to stay away from them.
THE MISSING YACHTS
There is a hypothesis in financial economics called an Efficient Market Hypothesis. It says that all known information about a company is already included in the share price. If it is true, then the movement of that share’s price is subject to new information. Now we as retail investors have no idea when or what that new piece of information will be. There are huge investment banking corporates with massive research teams dedicated to acting on this new information as soon as it breaks. We are and always will be at a disadvantage when pitted against the professionals.
However, this knowledge could be used to our advantage. Most of us are not chasing superior returns or trying to beat a benchmark. We could therefore simply do nothing when the going gets tough – we don’t need to chop and change our portfolio multiple times to try and squeeze out that extra ounce of performance. As the professionals do that, they incur transaction costs and friction that further reduces their performance.
In the meantime, we are sipping out G&T and watching Only Fools and Horses while our passive, index funds are hard at work in the background.
That becomes our margin of safety. It is better to have slow and steady returns over a long period of time than to rely on star fund managers promising superlative returns only for the vast majority of them to disappoint…all the time however, ensuring that they continue earning high management fees.
But where are the customers' yachts we may ask...
SUMMARY
A financial market consists of funds and shares. A share is a part of a company. It is a reflection of all the dividends or growth potential of that company that is expected over a very long period of time discounted to a present value.
By trying to choose individual shares, we may get lucky every now and then and hit a ten bagger (a share whose price increases by 10 times), but the chances are more likely that we will lose time and money if we start chasing returns from individual shares.
There is very little margin of safety with individual shares.
So, in summary, when choosing investments, we should go for a broad market index fund. If we really desire excitement while staying away from speculating, then we should choose an index fund of smaller companies. As Peter Lynch said, elephants do not gallop.
If there is time and inclination, we recommend reading: A Random Walk Down Wall Street by Burton Malkiel and The Little Book of Common Sense Investing by Jack Bogle (the founder of Vanguard).
They are eye-openers. They certainly opened ours.