Confronted to distill the secret of sound investing into three words, we venture the motto, MARGIN OF SAFETY.
Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.
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.
The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin.
Margin of safety and the principle of diversification are closely and logically aligned. One is correlative with the other. Even with a margin in the investor's favor, an individual security may work out badly. Margin guarantees only a better chance for profit than loss, but not that loss is impossible. As the number of positions is increased, the more certain does it become that the aggregate of profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.
Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion.
A true investment must have a true margin of safety. And a true margin of safety can be deomonstrated
It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity—provided that the buyer is informed and experienced and that he practices adequate diversification. For if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.
investment opportunities, since a careful analysis would have shown that the excess of value over price provided a large margin of safety. Thus the very class of "fair-weather investments" which we stated above is a chief source of serious loss to naive security buyers is likely to afford many sound profit opportunities to the sophisticated operator who may buy them later at pretty much his own price.
Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings.
A third business principle: "Do not enter upon an operation—that is, manufacturing or trading in an item—unless a reliable calculation shows that is has a fair chance to yield a reasonable profit...operations for profit should be based not on optimism but on arithmetic."
A fourth business rule is more positive: "Have the courage of your knowledge and experiencee. If you have formed a conclusion from the fact and if you know your judgment is sound, act on it—even though others may hesitate or differ." (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.) Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.