It is far more important to consider the question of 'what can I lose' than worrying about how much you can make when buying stocks. That is, of course, the direct and exact opposite of how most people approach the stock market.
Investors tend to look at a stock and ask "how high can this go?" and spend little to no time on "what happens if I am wrong?"
The average investor wants to figure out how many points higher Tesla (NASDAQ:TSLA) or Apple (NASDAQ:AAPL) can climb in a short period of time and never asks themselves what the business is worth and what can go wrong with this sexy, exciting stock story that might cause them to lose money.
Look to the Margins
The margin of safety in investing comes from the gap between what you pay and what the business is actually worth. Graham originally defined the margin of safety as a stock that was selling under depressed conditions and was worth less than the amount of bonds that could be safely issued by the company. Graham also compared the earnings yield on a stock to the prevailing interest rates to find a margin of safety.
Graham further added to the idea that when buying bargain issues, the margin of safety comes from the difference between the asset or appraised value of the company and the price paid for the shares.
In his classic book, aptly titled "Margin of Safety," legendary investor Seth Klarman echoes Graham by suggesting that investors would do well to focus on tangible assets. In the book, he opined, "How can investors be certain of achieving a margin of safety? By always buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles.”
Like Walter Schloss, he prefers companies where management and investors are on the same side of the table advising us to “Give preference to companies having good managements with a personal financial stake in the business.”
Graham and Klarman both reference the need to let the market work for you rather than against. The time to be buying a wide variety of stocks is when the market is down substantially and there are plenty of bargains around. Graham suggested that investors make the worst choice when buying lower quality companies with poorly defined earnings power under good market conditions.
Don't Be Fooled
A rising market hides a lot of flaws, and if investors are concentrating just of the prove movement of the stock rather than price in relation to the value of the company, they are often setting themselves up for losses that may not be recovered. While it is impossible to eliminate market risk, traders can erase much of the concern about short-term fluctuations by making 'margin of safety' the principle focus of investment activities.
It is very easy to get caught up in the stock market story of the day. The stock market is a place where our emotions and even our hard wired psychology can work against us. Buying stocks that are unpopular or even pretty much unknown, but are cheap and offer an adequate margin is not going to make for a great discussion at the office or the backyard BBQ.
Bragging Might Jinx You
Most individual investors want to talk about the hot stocks of the day like Facebook (NASDAQ:FB) or Google (NASDAQ:GOOG). Talking about a Liquefied Petroleum Products tanker firm selling at half of its book value like Stealth Gas is not going to make you a popular conversationalist.
Telling your friends and associates that you have been buying a bunch of little banks no one has ever heard of like ESSA Bancorp (NASDAQ:ESSA) or HopFed Bancorp (NASDAQ:HFBC) will most likely attract more blank stares than engaging conversation.
The key to long-term success in the stock market is to win by not losing. By focusing on the price paid for shares relative to the earnings and asset value of the firm instead of the exciting story or recent price action, traders create a margin of safety and allow the stock market to work for us instead of against us.
Tim Melvin is a value investor, money manager and writer. He has spent the last 27 years as in the financial services and investment industry as a broker, adviser and portfolio manager. He has also written and lectured extensively on the markets with his work appearing on RealMoney.com, DailySpecualtion.Com as well as several print publication including Active Trader and the Wall Street Digest. Click to watch Tim Melvin's FREE webinar and learn how to break through volatility using his value stock strategy.