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Three Words for a Sound Investing Strategy

Jun 24, 2019

Richa Agarwal, Research analyst

The stock market seems to be full of risks these days.

A new scam, the latest liquidity crisis in non-banking financial companies (NBFCs), a sudden government decision, surprising global events...

Sudden changes can swing the markets one way or the other.

It is little wonder the aam investor considers the stock market a most perilous place.

You might have heard the adage - No pain no gain.

It is usually used to describe something you don't want to do, but will benefit from it later.

Investing carries with it, a certain amount of risk. With that risk can come some amount of pain, but also some gain.

While it makes sense on a basic level, many investors confuse this with a common myth - High Risk = High Return.

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Sure, the general rule is that taking risks can be rewarding.

But most investors fail to consider this... higher the risk, the higher is the potential for return, and thus, less likely one will achieve that return.

The conclusion?

You need to minimise risk, to maximise gains.

What if I told you, there is a way to significantly cut down the risk in the stock market?

The world's richest investor, Warren Buffett, has been using this technique for more than 60 years.

Buffett learned the technique from his mentor, the father of value investing, Benjamin Graham. He incorporates it into every single investment decision he makes.

Graham called it 'Margin of Safety'.

  • "If you were to distill the secret of sound investment into three words, we venture the motto, Margin of Safety". - Benjamin Graham, The Intelligent Investor

While many tout this concept, very few of understand it.

To put it simply:

  1. First understand how much value a company creates for its owners now.
  2. To the best of your knowledge, estimate what value the company could create in the future.
  3. Understand what could materially affect your estimates and incorporate that in your estimate.
  4. Buy the stock only when it is available at a price well below what you've valued it at. That difference between the price and value is your margin of safety.

Where Buffett and Graham succeed and most investors and analysts fail is that they believe their own assumptions to be 100% correct.

The world is full of analysts who lay claim to be able to predict the future of a business to the smallest percentage point.

Analysts use various valuation methods. However, no matter how complex the valuation model is, it contains assumptions.

What happens when those assumptions go wrong?

They incur losses if their estimates don't come true.

Do not be party to this folly.

You might have noticed there is nothing in the list above about avoiding market volatility.

If you are invested in the stock market, you are inherently exposed to the risk of market crashes.

An intelligent investor should welcome market drops because it provides great opportunities to invest in companies trading at prices much lower than their fair values.

In short, the best way to avoid risk is by taking a bottom-up approach.

Develop a sound framework and always insist on a margin of safety.

And don't pay much attention to the broader market.

Be humble about your ability to estimate the future of a business. Always invest with Graham's 'margin of safety' in mind.

As simple as the concept is, you will come to realise its power to deliver profitable results over your investing lifetime.

Warm regards,

Richa Agarwal
Richa Agarwal
Editor and Research Analyst, Hidden Treasure

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