This article appeared first on The Stock Market Blueprint Blog.
Does more risk equal more return? Or, does investing with a margin of safety reduce risk and increase returns?
Conventional investment advice suggests that high returns are only achieved when taking high risks. This makes sense to some degree.
If you put money under a mattress, the return is zero and so is the risk. If you play roulette and put a million bucks down on any single number, the potential return is massive but so is the risk.
| American Roulette Odds | ||
| Bets | Payout | Probability |
| Odd | 1:01 | 46.37% |
| Even | 1:01 | 46.37% |
| Black | 1:01 | 46.37% |
| Red | 1:01 | 46.37% |
| 1-18 | 1:01 | 46.37% |
| 19-36 | 1:01 | 46.37% |
| 1-12 | 2:01 | 31.58% |
| 13-24 | 2:01 | 31.58% |
| 25-36 | 2:01 | 31.58% |
| Single Number | 35:01 | 2.63% |
| Combination of two numbers | 17:01 | 5.26% |
| Combination of three numbers | 11:01 | 7.89% |
| Combination of four numbers | 8:01 | 10.53% |
| Combination of six numbers | 5:01 | 15.79% |
| Combination of 1-2-3-0-00 | 6:01 | 13.16% |
| Source: http://www.rouletteonline.net/odds/ | ||
This logic may make perfect sense when applied to gambling, but it does not stay true when applied to the stock market. Rather than obtaining high returns through risky stocks, prudent investors achieve great long-term results from buying safe stocks with a margin of safety.
Does Volatility = Danger?
To figure out how this works, it’s important to understand what risk is. The dictionary definition of risk is: exposure to a danger or loss. The academic definition of financial risk is: volatility. Volatility in the stock market is no more than frequent changes in price.
So the first question is, do frequent price changes expose investors to danger or loss? The simple answer is NO.
Investors are only exposed to danger or loss when there is a real chance that they will lose money. Frequent price changes do not cause permanent loss of principle.
Does Volatility = Reward?
The second question is, does more volatility equal a greater return? The answer again is NO.
There is no scientific evidence which suggests that the more volatile an investment is, the higher return it will produce.
It’s important to understand what a safe investment is. Howard Marks, Chairman and Co-Founder of Oaktree Capital Management – an investment firm which manages over $97 billion –believes any stock can be safe, as long as it’s purchased at a low enough price.
Based on his opinion as expressed in the book The Most Important Thing, Marks believes the traditional risk/return ratio is misleading: “Riskier investments absolutely cannot be counted on to deliver higher returns.”
He goes on to say, “High return and low risk can be achieved simultaneously by buying things for less than they’re worth.”
Investing with a Margin of Safety
The key phrase is buying things for less than they’re worth. This is accomplished through investing with a margin of safety.
Stock investors need to determine the intrinsic value of a particular company and then buy ONLY when the stock price is below the determined value.
When the stock price is lower than the intrinsic value, the difference is considered a margin of safety.
Seth Klarman – billionaire fund manager and author of the book Margin of Safety – explains that investing with a “margin of safety” allows room for: “error, imprecision, bad luck, or the vicissitudes of the economy and stock market” in any value investment approach.
Investing with a large safety cushion between your purchase price and the company’s intrinsic value is an absolute necessity for anyone looking to building wealth in the stock market.
Intrinsic Value: Science or Art
No two investors analyzing the same stock will come up with identical intrinsic values. Forecasting earnings and interpreting financial statements require too many assumptions to objectively pinpoint an exact amount.
However, it is possible to find the range of a company’s value. To paraphrase Benjamin Graham, You can know a woman is old enough to vote without knowing her exact age.
Because calculating intrinsic values is not an exact science, establishing a margin of safety is required before the stock can be considered an investment. Value investors only buy stocks that are trading at large discounts to their intrinsic values.
The larger the discrepancy, the better the investment.
Playing it Safe
Insisting on investing with a margin of safety is arguably the number one factor that sets value investors apart from all other market participants. It is the only way to minimize errors and maximize returns.
Without it, an investor whose analysis is wrong could end up paying more for a stock than the company is worth, resulting in an inadequate return on investment.
How great a margin of safety is needed depends on two criteria: the investor’s risk tolerance and the predictability of the company’s future earnings.
A more cautious investor should require a steeper discount on the stock price relative to intrinsic value. Likewise, if a company’s profits are dependent on several complicated and unpredictable factors, a larger safety margin is necessary.
Avoiding risky investments does not require sacrificing decent returns. It is possible to play it safe without putting all your money under your mattress.
Mitchell Mauer is the Founder of TheStockMarketBlueprint.com. The Stock Market Blueprint is a site that finds value stocks for investors building long-term wealth. The site’s investment philosophy is anchored in principles established by Benjamin Graham and his most reputable followers over the last 100 years.
