Seth Klarman's Bite-Sized 'Margin Of Safety': Part 1

Shutterstock photo

Seth Klarman ( Trades , Portfolio )'s "Margin of Safety" is one of the best and most highly valued investment books of all time. There are many key takeaways from the text and advice that will help you shape and build a value investing strategy.

Below I've tried to tell the Margin of Safety story in a few quotes, picked out for their potency.

The story

The book starts with this quote on the need to remove emotion from investing:

"Unsuccessful investors are dominated by emotion. Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear. We all know people who act responsibly and deliberately most of the time but go beserk when investing money. It may take them many months, even years, of hard work and disciplined saving to accumulate the money but only a few minutes to invest it. The same people would read several consumer publications and visit numerous stores before purchasing a stereo or a camera yet spend little or no time investigating the stock the just heard about from a friend. Rationality that is applied to the purchase of electronic and photographic equipment is absent when it comes to investing."

I think this is one of the most powerful quotes I've seen on investing psychology. Most investors fail to make any money from stocks because they just cannot deal with the pressure.

This is something almost every investor has to get used to. The only way to break the mold is to preserve and, more importantly, do your research:

"Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return. Anyone would enjoy a quick and easy profit, and the prospect of an effortless gain incites greed in investors. Greed leads many investors to seek shortcuts to investment success. Rather than allowing returns to compound over time, they attempt to turn quick profits by acting on hot tips. They do not stop to consider how the tipster could possibly be in possession of valuable information that is not illegally obtained or why, if it is so valuable, it is being made available to them. Greed also manifests itself as undue optimism or, more subtly, as complacency in the face of bad news. Finally, greed can cause investors to shift their focus away from the achievement of long-term investment goals in favor of short-term speculation."

I have written before that rigorous research is one of the best ways for investors to reduce risk. The more you know the business, the less likely you will be inclined to sell if the stock drops 40% or more. If you truly know and understand the business is undervalued, it is easier to commit to holding through thick and thin.

Research helps reduce risk and helps you control your emotions as, ultimately, the future is impossible to predict. The sooner you realize this, the better:

"The future is unpredictable. No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survey and even prosper under any circumstances. Bad luck can befall you; mistakes happen. The river may overflow its banks only once or twice in a century, but you still buy flood insurance on your house each year. Similarly we may only have one or two economic depressions or financial panics in a century and hyperinflation may never ruin the U.S. economy, but the prudent, farsighted investor manages his of her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity."

Research and a long-term mentality are key to reducing risk and minimizing the chances of a total capital loss. But there will be occasions where avoiding a total loss is not possible. No matter how much research you do, there may be problems bubbling below the surface that even management is not aware of:

"It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Not only may questions remain unanswered; all the right questions may not even have been asked. Even if the present could somehow be perfectly understood, most investments are dependent on outcomes that cannot be accurately foreseen. Even if everything could be known about an investment, the complicating reality is that business values are not carved in stone. Investing would be much simpler if business values did remain constant while stock prices revolved predictably around them like the planets around the sun. If you cannot be certain of value, after all, then how can you be certain that are you buying at a discount? The truth is you cannot."

In these cases, it's best not to dwell on the outcome. The market is full of unknowns and investors can only do so much to protect against the risk of something going wrong. Assuming the worst-case scenario, rather than the best and targeting a return, is the only way to make sure that if the whole investment case blows up, you can walk away with some percentage of your capital intact.

"Targeting investment returns leads investors to focus on potential upside rather on downside risk ... rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk."

Premium Members

This article first appeared on GuruFocus .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Stocks
Referenced Symbols: INOD , AY , CARS , FORM ,

More from GuruFocus




Stock Picks, Portfolios

Research Brokers before you trade

Want to trade FX?