Seth Klarman (Trades, Portfolio) is widely regarded as being one of the best investors of all time. His hedge fund, Baupost, has produced an average return of nearly 20% per annum for investors since inception thanks to his skill in finding value investments.
Looking at these returns, it would be easy to conclude that Klarman has a gift others don't, or that he is using an investment strategy that's impossible to replicate.
But this couldn't be further from the truth.
Klarman has spoken about how he invests many times in the past, and in reality, his approach to the market is quite simple.Ă‚
Step one: Don't lose money
The first quote is taken from a lecture Klarman gave at the MIT Sloan Investment Management Club on Oct. 20, 2007:
"For 25 years, my firm has strived not to lose money — successfully for 24 of those 25 years– and, by invest and cautiously and not losing, ample returns have been generated. Had we strived to generate high returns, I am certain that we would have allowed excessive risk into the portfolio– and with risk comes losses. Some investors target specific returns. A pension fund, for example, my target an 8% annual gain. But if the blend of asset classes under consideration fails to offer that expected result, they can only lower the goal– which foremost is a non-starter– or invest in something riskier than they would like...The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk."
This quote can be summed up quite simply. Investors should always prioritize risk avoidance. Rather than trying to work out how much you stand to make, you should first calculate how much you could lose if the scenario you envisage does not play out as expected.
Step two: Find the margin of safety
And when you have established the level of risk involved, it is critical to buy with a margin of safety because trying to predict the market accurately is impossible:
"Buying stocks at an appreciable discount from the value of the underlying business is one strategy that provides a roadmap to successfully navigate not only through good times but also the turmoil. Buying at a discount creates a margin of safety for the investor — room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies."
When you've found a stock with an attractive risk/reward ratio, and brought in with a suitable margin of safety, the final step is to wait for the value to be unlocked.
Step three: Patience is a virtue
Unfortunately, this is where most investors stumble. Sitting and doing nothing for months or even years, is too dull for most investors and they can't resist overtrading or jumping out of the market at the first sign of trouble. To be successful in investing you need to take a long-term focus and not be distracted by short-term issues:
"Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return. Anyone would enjoy a quick and easy profit, and the prospect of an effortless gain incites greed in investors. Greed leads many investors to seek shortcuts to investment success. Rather than allowing returns to compound over time, they attempt to turn quick profits by acting on hot tips. They do not stop to consider how the tipster could possibly be in possession of valuable information that is not illegally obtained or why, if it is so valuable, it is being made available to them. Greed also manifests itself as undue optimism or, more subtly, as complacency in the face of bad news. Finally, greed can cause investors to shift their focus away from the achievement of long-term investment goals in favor of short-term speculation." -- Seth Klarman (Trades, Portfolio) Margin of Safety
Disclosure: The author owns no stock mentioned.
