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Robert Stephens, CFA
Robert Stephens, CFA
Articles (369) 

Seth Klarman on Accepting Your Limitations When Investing

Understanding what you don’t know could enhance your returns

April 16, 2020

Seth Klarman (Trades, Portfolio) has a successful track record of generating high returns. The Baupost Group investment partnership that he manages has recorded an annualized gain of nearly 20% since its inception in 1983.

However, it may surprise you to find out that Klarman readily admits there are a number of areas in which he has limitations as an investor. Among them are being unable to predict the future direction of the stock market and failing to accurately value businesses on a consistent basis.

Through accepting those limitations and focusing your efforts on areas where a competitive advantage over other investors can be obtained, it is possible to improve your portfolio’s performance, according to Klarman's example.

Market forecasts

An area of focus for many investors is seeking to predict the future direction of the stock market. This is not surprising, since being able to accurately anticipate the market’s movements would allow an investor to position their portfolio so that it benefits from bull markets and bear markets.

Klarman does not seek to guess the market’s future movements. According to him, “In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.”

Instead of trying to predict the wider market’s movements, Klarman focuses on unearthing companies with strong fundamentals while they trade at low prices. This has been a more efficient use of his time compared to trying to anticipate the stock market’s movements.

Company valuations

Valuing a stock can be undertaken via a variety of methods using a range of ratios, formulas and viewpoints. As well as being highly subjective, valuing a business is often based on assumptions that will not necessarily be met.

For example, the price-earnings ratio is based on recent levels of profitability that could change dramatically in the future. Likewise, the price-book ratio is based on asset values that could fall in a recession. Klarman appreciates that there are, therefore, limits to the ability to accurately value stocks:

“A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss”.

By demanding a margin of safety when he buys stocks, you simultaneously reduces risk and improve return potential. Since valuations are subject to change depending on how the future unfolds, this could be a sensible step for all investors to take when analyzing any company.

Relying on investment professionals

As well as accepting your own limitations, Seth Klarman (Trades, Portfolio) believes you should acknowledge that the ability of other investors is also finite. This extends to investment professionals who, in some cases, may have views that do not necessarily improve your overall returns when acted upon:

“When a Wall Street analyst or broker expresses optimism, investors must take it with a grain of salt. Wall Street research is strongly oriented toward buy rather than sell recommendations. There is more business to be done by issuing an optimistic research report than by writing a pessimistic one”.

Even if an investor has greater experience or qualifications than you do, it does not necessarily translate into better portfolio performance. They may have a different time horizon or investment strategy, for example.

By undertaking your own research into the fundamentals of specific companies and sectors to find undervalued opportunities, rather than trying to predict the future or rely on the opinions of others, you could improve your portfolio’s performance in the long run.

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