For each of your investments, what’s your margin of safety?
Brilliant investor Seth Klarman explains this idea best in his 1991 opus, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.
Klarman may not be a household name, but he should be. Since founding his hedge fund, the Baupost Group, in 1982, he has produced one of the best investment track records of all time.
As Klarman writes…
There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with 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, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.
It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.
I’ll share a few steps that can help you put this cushion in place.
But first, let’s talk about why now is a crucial time to remember the value of having margin of safety in our portfolios…
Despite the volatility, 2020 proved to be a good year for most investors.
That’s great news. But because stocks, bonds, and preferred stocks are so pricey already based on virtually any historical measure, few assets have any margin of safety today.
In other words, it’s hard to find investments that provide attractive returns for the risk of loss that they offer.
So how should you play this? Should you stay fully invested in the highest fliers and capture the incredible returns that are possible right near the end? Or is it time to listen to Seth Klarman?
Here’s another one of Klarman’s gems from Margin of Safety…
The most important metric is not the returns achieved but the returns weighed against the risks incurred. [At Baupost], we have consistently tried not to lose money and, in doing so, have not only protected on the downside but also outperformed.
In other words, these two desires – producing continued strong returns and protecting your assets from losses – are not at odds.
But the level to which you pursue them may vary depending on your investment goals… Are you looking for unfettered capital gains, or do you prefer steady income? Or, are you more interested in preserving your wealth than growing it?
You can boost your margin of safety by holding more dry powder (cash) and portfolio protection (like short positions). And you should reinvest only where you feel far more comfortable about your reward-to-risk ratio.
Another way to position yourself safely is to own only the world’s best and most durable businesses – ones that should take more share of their respective industries in a downturn. When you focus on owning these resilient stocks for the very long term, it gives you a huge advantage over most investors.
This process of continuing to maintain a margin of safety even while shares appreciate is something that Klarman also addressed. How does he say to do this?
- By replacing current holdings as better bargains come along.
- By selling when the market price of any investment comes to reflect its underlying value.
- By holding cash, if necessary, until other attractive investments become available.
These are the kinds of strategies you should put in place this year. Despite a chaotic 2020, the market has soared. So have valuations – and they could soar much higher before this bull market ends.
If you give yourself a greater margin of safety now, your portfolio will thank you – and you’ll position yourself for a profitable 2021.
Good investing,
— Austin Root
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Source: Daily Wealth