The Intelligent Investor: “Margin of Safety” as the Central Concept of Investment

intelligentThis is the twenty-first (and last) in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the twentieth and final chapter, which is on pages 512 to 524, and the Jason Zweig commentary, on pages 525 to 531.

We’ve reached the end of the trail.

This chapter closes out The Intelligent investor by discussing the true message behind the book: companies that provide a great value are quiet, solid, and able to resist competition. They just pay out their dividends and keep doing what works.

Graham sums this up in one concept: the “margin of safety.” Simply put, it’s the idea that a company has established such a stable business that the company can succeed through many environmental changes. The economy goes up or it goes down – either way, the company is safe and stable. Competitors come and competitors go – the company survives. Management changes – the company rolls right through it.

Companies that have established themselves with such steadiness are the real value stocks. Quite often, companies like this are actually seen as boring (particularly if the company’s business is not in an exciting sector) and thus are often ignored in the “hype” talk on CNBC and the like. That means there aren’t a whole lot of buyers, even though the company is very strong, and that results in an undervalued stock. You buy it for cheap, ride the stability, and collect dividends along the way.

Sounds like a great plan to me.

Chapter 20 – “Margin of Safety” as the Central Concept of Investment
A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

Graham takes this point a step further, arguing that diversification is strongly correlated with margin of safety. In effect, Graham states that you introduce some additional margin of safety into your portfolio when you own a widely diverse array of value stocks that each have significant margin of safety.

Graham’s final note is pretty simple: investors get in trouble when they abandon their basic principles in the heat of the moment. One must approach investing with a set of fundamental principles and not abandon them in the heat of the moment.

Commentary on Chapter 20
Zweig closes out this final chapter by arguing that psychology is a major part of investing, one that many people overlook in the rush to find the big bargain. He goes so far as to argue that people are the primary risk in their own investing – poor decision making and abandonment of principles results in far more loss than an investment gone wrong.

Zweig actually ties this to Pascal’s wager, a famous suggestion by the French philosopher Blaise Pascal in which he argues that, since God’s existence cannot be determined through reason, one should behave as though God does exist, since living in that way (as opposed to living as though God does not exist) provides much more gain than loss. Similarly, since one cannot prove what will happen in the future with investments, we’re better off living by our investing principles than playing it by ear.

This is the final entry in the book club reading of The Intelligent investor. I hope you enjoyed it as much as I did.

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