Seth Klarman wrote an investing classic called – Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. There’s one passage in particular in which Klarman encapsulates his entire value investing strategy saying, “A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes.”
Here is an excerpt from the book:
The focus of most investors differs from that of value investors. Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose. Institutional investors, in particular, are usually evaluated—and therefore measure themselves—on the basis of relative performance compared to the market as a whole, to a relevant market sector, or to their peers.
Value investors, by contrast, have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.
If investors could predict the future direction of the market, they would certainly not choose to be value investors all the time. Indeed, when securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public’s favorites. When the market becomes fully valued on its way to being overvalued, value investors again fare poorly because they sell too soon.
The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism. Value investors invest with a margin of safety that protects them from large losses in declining markets.
Those who can predict the future should participate fully, indeed on margin using borrowed money, when the market is about to rise and get out of the market before it declines. Unfortunately, many more investors claim the ability to foresee the market’s direction than actually possess that ability. (I myself have not met a single one.) Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments.
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