Wednesday, March 28, 2012

Seth Klarman: Margin of Safety

From the book Margin of Safety by Seth Klarman:

"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."

When a money manager grabs a headline for spectacular returns achieved the question that follows should be:

At what risk of permanent loss of capital?

This is especially true if the returns were accomplished over a shorter time horizon. The problem is, of course, unlike returns it's not possible to precisely measure the risks that were taken to achieve returns.

It's easy to promote returns.

It's much harder to promote effective risk avoidance.

Consider two money managers:

Money Manager 1: Earns 14 percent per year for six years for investors then a bear market kicks in. The market value of the portfolio drops 30 percent in year seven.

Money Manager 2: Earns 10 percent per year for six years for investors then a bear market kicks in. The market value of the portfolio drops 10 percent in year seven.

Who had the better seven year returns?

Money Manager 2

Who's portfolio performed better on the downside during a bear market?

Money Manager 2

Who do you think attracted more investors in the first six years?

It's best to not get enamored with spectacular returns of others unless the risks taken to achieve those returns are well understood.

Downside risk is regulated by judging value well and having the discipline and patience to wait and buy only when there's a meaningful discount to that value (and selling, at times, under the opposite conditions).

Unfortunately, the evidence suggests that many do the opposite. The tendency of investors buying high when it feels safe (usually during a spectacular performance frenzy) then selling out of fear and/or disgust when it temporarily all goes south.

Those with any doubt should compare money flows into equity mutual funds in 1999 to the money flows of more recent years.

Successful value investors develop (or have) the ability to be less susceptible to this risky behavioral pattern.

This all too predictable pattern takes away the investors best possible method of reducing risk.


Paying a low price relative to value (and sound judgment of value) regulates the downside risk for an investor.

The chance to buy an investment you understand well with the largest possible margin of safety usually happens in brutal bear markets when nothing seems to be going right.

It rarely feels good at the time.


* No matter how much someone wants to believe it, academic or otherwise, there will never be a single variable that captures the risks of an investment. Beta may lend itself to neat calculations but it's worthless when it comes to gauging risk. Risk is always a bunch of mostly not quantifiable judgments.

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