Defining and Understanding Value Investing

If any investment concept got hijacked during the epic bull market that preceded the biblical financial meltdown of 2008 it was "value investing."  But however susceptible the term may be to manipulation, the qualities that define value investing are immutable:


Value investing is the purchase of a stock (or other financial asset)

 at a discount to its calculated intrinsic worth


That discount is known as the investor's margin of safety.


Note that the value investor consistently strives to think in terms of specific, calculated values and probabilities.  A value investment requires two financial calculations: The intrinsic worth of an asset (its underlying economic value, which we discuss in the Investment Analysis section), and the discount to that valuation, which comprises the margin of safety.


If the investor isn't subjecting both intrinsic value and margin of safety to considerable analysis and mathematical/financial estimation, it's impossible to describe what they're doing as value investing.  In fact, unless blind gambles are included in the definition, it's hard to describe what they're doing as investing at all.


Because value investing frequently entails a considerable amount of patience, many investors have adopted the dangerous habit of confusing a long-term investment horizon with value investing.  However, to state perhaps the painfully obvious, buy-and-hold is neither a proxy nor a substitute for value investing.  Only a fool would believe that the act of holding on to a poor investment for an extended period would somehow transform it into a good value. 


For an investment to be truly attractive in risk/reward terms, one must be able to purchase it at a significant discount to its intrinsic value today, not what its value may or may not be tomorrow.  There's no margin of safety in speculating on the latter.  The value investor is waiting for the market price to catch up to and reflect the intrinsic value today, not relying on the intrinsic value increasing dramatically in the future. 


Much like the rising tide that lifts all ships, the 18-year equity bull market that began in 1982 enabled investors to adopt any number of highly suspect practices. Perhaps the most egregious was their characterizing companies of obviously questionable value and very uncertain futures as "value investments."  There is of course a huge difference between (1) waiting for the market to recognize existing value and (2) hoping that a company will create future value; the latter has absolutely nothing to do with value investing and typically comprises a very poor risk/reward trade-off.


If the margin of safety relies upon an unproven future

rather than a continuation of normalized historical performance,

it's not a value investment.


Whether short-term (as in the case of rational speculation, explained below) or long-term (as in a long-term equity holding), value investing is the exploitation of an explicit, calculated disparity between the price of a given security and a conservative assessment of its underlying intrinsic value.  Individuals who assert that "buy-and-hold" is the only type of value investing are confusing a label with a discipline.  Value investing is identified by depth of analysis and degree of certitude, not security type or holding period.


Another novice error - and probably the least defensible - is citing the inability to calculate a highly specific intrinsic worth as an excuse for not conducting rigorous analysis to begin with.  More than transparently lazy, from an intellectual standpoint this is utterly bankrupt. 


It suffices to say that the intrinsic value of an investment does not have to be highly accurate for the discount to be highly obvious.  More to the point, most attractive value investments are characterized by such a wide disparity between the current price and the intrinsic value that the margin of safety is all but impossible to overlook.  Supreme Court Justice Potter Stewart's famous conclusion regarding pornography may be even more applicable to value investments: A universally precise, consistent definition may not exist, but you know it when you see it.  At some point a subjective difference becomes so pronounced that it is undeniably, objectively obvious...


It's both reasonable and accurate to assert that many assets and businesses are simply not susceptible to conclusive valuation because their financial futures are, for various reasons, too uncertain.  Naturally, it's impossible to know what something may be worth if we can't generate reliable projections of its future financial performance.  But this begs an obvious question: If we can't develop an honestly reliable estimate of what an investment is worth, why not just avoid it?  Nobody is forcing us to buy anything. 


As Bernard Baruch once said, it's not the return on your money but the return of it that's most important.  Any common fool can assume great risk in return for the chance to win great reward.  The goal of intelligent investing is to earn an attractive return while exposing your capital to as little risk as possible. 


Efficient Market Theory, and Why You Should Ignore It

A central premise of authentic value investing is that one can uncover value that others have yet to recognize and profit from the eventual recognition of that value.  Adherents of the Efficient Market Theory ("EMT") and its close cousin Modern Portfolio Theory ("MPT") would dispute this.  EMT adherents believe that, at any given time, the price of a security reflects all information relevant to that security.  Moreover, if the market is efficient, the individual investor can't beat it because that investor alone can never exceed the efficiency of all of the other investors combined (i.e., the market).  The individual's efforts are theoretically her undoing, because those same efforts contribute to and create the larger efficiency she can't outperform.

This argument is interesting, but contains at least one fatal oversight:  With enough stimulus, any herd will stampede off of a cliff.  It will pursue stupid, even fatal courses of action.  Thus, even if life in the herd is safe most of the time, it's not necessarily where one wants to be all of the time.  Translated into investment terms, even if the market is efficient, it's not efficient ALL OF THE TIME.  The market runs on human input, and humans err, overreact, and generally make mistakes all of the time.  Thus, there will always be opportunities for outperformance.  The market is a melting pot of emotion and overreaction.  As Warren Buffet has noted,

"When the price of a stock can be influenced by a 'herd' on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market prices rationally.  In fact, market prices are frequently nonsensical."

One can in fact assert that this irrationality has only increased with greater participation in the equities markets.  The more people out there investing who have not the slightest clue what they're doing, the greater the irrationality quotient - remember "irrational exuberance"? 

If you think the market is efficient, here's a simple test for you to conduct (you're forewarned that it will require some time):

Read the last 5 annual reports and the last 6 10-Qs (quarterly reports) of a well-known company that you're interested in investing in (you can find the link for the SEC database containing this information online at Resources).  Make a list of the questions that occur to you about the company, as well as the items of interest that you run across in the reports.  Then call your stockbroker, or any other individual - every other individual, for that matter - that you might seek out in making an investment decision, and share those questions and issues of interest with them.  What you're going to find out is that most if not all of them have little grasp of the details that you are now familiar with.

Consider also the composition and turnover of the average mutual fund.  The typical fund has hundreds of positions and the average turnover is over 200%.  The managers of these vehicles couldn't possibly understand their investments in any depth.  Given their lack of knowledge, they're primed to panic.  Making matters worse, based on the system under which they're employed and compensated, fund managers are also incentivized to panic.


The end goal of most fund managers is to not get fired, which is neither surprising nor particularly despicable.  They're human, and they logically want to continue to receive their paychecks and pay their mortgages.  And no fund manager will ever get fired for producing returns that approximate the market overall.  In fact, because most in the business believe that it's practically impossible to consistently beat the market, only significant underperformance relative to the overall market will guarantee a pink slip.  This is why fund managers sell stocks that go down and buy stocks that go up - they're desperately afraid of owning a "loser."  Fund management after all is a business, and it's run by fund managers who are in the business of staying in business, not making returns.  As Warren Buffet has noted, "Modern Portfolio Theory tells you how to be average.  But I think almost anybody can figure out how to do average by the fifth grade."


Another distinction worth drawing is the difference between a market that is efficient vs. the pricing of an individual security.  It is a much easier (although still doomed) argument to make that the market overall is an efficient arena.  The market as a whole is ultimately so vast, it seems logical that the sheer number of participants will ensure efficient pricing.  However, extrapolating that line of reasoning to the price behavior of an individual security is more difficult because the number of price-making participants drops dramatically.  The name of the school is Efficient Market Theory, not Efficient Stock Theory.


Ultimately, EMT is useless to the investor.  The market is more than adequately inefficient to provide a regular flow of outstanding investment opportunities.  If you work hard, do your own thinking, and stay detached when everyone around you is panicking or getting emotional, you can produce returns that substantially exceed those of the market.  In many respects it's a perfect example of ignorance truly being bliss - maintain a healthy disdain, because the intelligent investor can frequently profit from managers more interested in paychecks than profits.  In this sense, the investor's greatest enemy is the one in the mirror.


Temperament, Time and Prices

The prices of securities representing ownership stakes in corporate entities have a habit of bouncing around.  It's the nature of any situation where the price is set by a heterogeneous, emotional herd.  However, even if we can't control price behavior, we can control how we react to those price fluctuations.  Exercising this discipline is may be more important than any other attribute the investor brings to the table.  Emotional detachment is indispensable.

Disciplined investing is about controlling one's emotions and

being dispassionate in the calculation of probabilities.

If, as an investor, you're purchasing securities at a steep discount to what you believe is their intrinsic worth, you're only able to do so because you are exploiting a temporary inefficiency.  The question is whether you have the confidence to ride out the same inefficiency you're exploiting.  Ultimately, your position is that the majority of investors (whose "vote" is represented by the current purchase price) are wrong.  You're going against the herd.


Volatility is your friend.


How long will it take the crowd to come around, and where will the price go in the meantime?  You can't predict this, which means you may see the price go down - perhaps a lot - before you see it go up.  How willing are you to be "wrong," and for how long? 


Benjamin Graham used to say that the stock market is a voting machine in the short-term, but a weighing machine in the long run.  By this he meant that in the short-term, prices could go anywhere, but over the long term economic reality and the efficiency of the market would cause the security's price to accurately reflect the underlying economic fundamentals.  One can depend on the market to eventually "make efficient" those temporary pricing anomalies - there's just no forecasting how long it will take the market to remedy the mispricing.


Outside of the stock market, most individuals are very comfortable in timing consumer purchases to take advantage of declines in price, such as buying after the holidays, waiting for clearance sales, etc.  However, the average person takes a dramatic departure from this simple logic when they turn to investing.  Why?  Because unlike a coat they purchase during an after-Christmas sale, with securities they seldom understand the value of what they're buying to begin with, and thus have no mental landmark for gauging whether it's over- or under-priced. 


It is in itself fascinating that most individuals know more about the $300 jacket they purchase than the $30,000 worth of company stock they own.  This is yet another nail in the coffin of the notion that the market is consistently efficient: Why would so much ignorance on the individual level somehow add up to efficiency in aggregate? 


The key is always specific knowledge.  Whether a drop in price is justified or an opportunity depends upon the specifics.  (A discussion of how to estimate what a security is worth can be found in the Investment Analysis section.)

All of the best public equity funds are private equity in drag.


As an investor as well as an owner, one has no gains or losses until the position is sold.  This is the way the IRS looks at it, and so should you.  Prices will fluctuate constantly, and when a piece of a business is purchased via the ownership of shares and the price subsequently plummets, the intelligent response is to revisit one's reasons for investing to begin with. 


Changing prices should trigger analysis, not necessarily action.


As discussed above, the market may be efficient most of the time, but not all of the time, especially when it comes to individual security prices.  Accepting that individual securities are also efficiently priced most of the time, it's important to acknowledge that a dramatic change in price may reflect a shift in the underlying fundamentals of the investment.  Accordingly, it only makes sense to revisit one's analysis in response to such a change.  The underlying operating results are always what should drive the decision to buy or sell, and a change in price should be welcomed as an invitation to return to one's analysis and re-confirm all of the reasons why the investment was attractive to begin with.


If those reasons are still intact, there may be an opportunity to buy more, but there's certainly no reason to reduce the position.  The market is merciless with those who panic - which is why it's so important to have performed very thorough analysis on the stocks one owns to begin with.


In-depth knowledge is the only reliable source of confidence;

all else fails in the face of panic.


Anyone who doesn't read the 10Ks, 10Qs, and supplementary filings and do their own financial modeling and projections cannot possibly know what they're talking about.  If I'm researching a company that's been in business for some time, it's not unusual for me to go back 10 years in the filings and read them all.  I almost always go back at least 5 years (some companies haven't been around that long, but most I find interesting have been).  Anyone who says that there's "not enough time" to do so or that it's "unnecessary" should invest in an index fund or give their money to a manager willing to do the totality of the work.


Everyone that I respect in the investment world does their own financial analysis.  By that I mean they take the information contained in SEC filings and build a spreadsheet so that they can rigorously test their financial assumptions about the company.  Anyone with any investment experience knows that simply accepting what a Wall Street analyst says about a company is a one-way ticket to financial oblivion; almost all of them are conflicted by virtue of their position, and only a minute fraction have the fortitude to say "Sell."


What Equity Returns Are Worth The Risk?


Annual percentage change in S&P 500 w/ dividends included : 1965 - 2011 
1965 10.0 1981 (5.0) 1997 33.4
1966 (11.7) 1982 21.4 1998 28.6
1967 30.9 1983 22.4 1999 21.0
1968 11.0 1984 6.1 2000 (9.1)
1969 (8.4) 1985 31.6 2001 (11.9)
1970 3.9 1986 18.6 2002 (22.1)
1971 14.6 1987 5.1 2003 28.7
1972 18.9 1988 16.6 2004 10.9
1973 (14.8) 1989 31.7 2005 4.9
1974 (26.4) 1990 (3.1) 2006 15.8
1975 37.2 1991 30.5 2007 5.5
1976 23.6 1992 7.6 2008 (37.0)
1977 (7.4) 1993 10.1 2009 26.5
1978 6.4 1994 1.3 2010 15.1
1979 18.2 1995 37.6 2011 2.1
1980 32.3 1996 23.0    
 Average 10.8%
        Avg. '65 - '99  13.6%


Given the returns offered by the S&P over the last 40 years, it's reasonable to ask why one should invest in individual equities at all.  As the table above indicates, from 1965 one could have earned approximately 10.5% annualized by doing nothing more than owning an index fund (or a basket of S&P stocks).  If that same investor was fortunate enough to have taken their exit in 1999, she would have earned 14% during that period. 


Consider the issue from another perspective:  If the market index returns approximate 9-10% annually over an extended period and one is willing to remain invested over the long term, what is the only assumption one has to make?  Ultimately, that (1) the US and global economy won't blow up during that period or (2) they will not for personal reasons be forced to sell during a period of market decline.  Provided the world doesn't have an economic meltdown, being invested in the index stands a good chance of earning an adequate return over the long run.  If there are concerns about exposure to the US economy exclusively, one could - for example - invest in index funds representative of the 7 largest economies of the world.  In that case, even if the US economy falters, one still stands a chance of a decent return.


That the entire world economy will not stagger to a halt and suspend there for the next 35 years is a much easier assumption to make than the massive leap of faith one takes when handing their money to a professional money manager, 90% of whom underperform the market.  It only follows that it would be irrational to pay for active money management if the return goal is only approx. 10%.


To earn approximately 8-10% annualized returns over the long term by owning a blend of the major indices, the only assumption one probably has to make is that aliens (or terrorists) will not obliterate the planet. 


By comparison, to assume that an individual investment manager will deliver comparable results

when 90% underperform the market, one has to make an almost illogical leap of faith.  Conclusion?


If returns in the territory of 8-10% are adequate and one is willing

to stay invested over the long term and ignore short-term volatility,

it's foolish to not simply invest in the indices. 


Conversely, if one is interested in owning individual equities,

returns had better be much, much higher than 10%. 

Anything less fails to compensate for all the added risk.


Prior to the financial crisis of 2008, the US was concluding the greatest bull market in equities in the country's history.  Unless the investor expects a repeat of that performance, the idea that one can simply purchase an index fund and accrue the same attractive returns of the last 35 years is probably misled.  But that's a moot point because most investment managers underperform the index regardless of what the index performance is.


To be accurate, owning a concentrated portfolio of individual equities in lieu of an index entails risk beyond the basic failure to outperform the broader indices.  Investors often overlook the fact that equities stand last in line in the capital structure.  Many stockholders seem to confuse ownership of the business with ownership of the assets.  Shareholders own the business, but after employee salaries, trade creditors, and the IRS (among other parties), it's the bond holders who own the assets.  Stockholders' interests are subordinated to almost everyone else's.  Theirs is a residual claim.


If a company has $100 mil. in net assets, and there is $100 mil. of debt outstanding, one could argue that in effect the shareholders own nothing.  At least nothing tangible.  In the event that the business were to expire (and if you don't think that is likely, compare a list of NYSE stocks from 60 years ago with one today), in bankruptcy the shareholders would likely receive nothing, or next to nothing.  Heard of WorldCom?  After all was said and done in that nightmare, the bondholders received slightly more than 30 cents on the dollar, and the shareholders received nothing.  How about Enron?  Adelphia?


In considering what comprises an adequate return, it's common practice in the investment industry to look at rates of return not in isolation, but in reference to all other possible investments.  Every option is evaluated in contrast to the alternatives, viewed along a spectrum of less risky to extremely speculative.  The most conservative investment pays what is referred to as the "risk-free rate," and for the better part of the post-war era this rate is the one paid on the benchmark 30-year US Treasury Bond (or similar bond of shorter maturity, such as the 10-year maturity). 


Because the credibility and prudence of the US Federal Reserve and the strength and vitality of the US economy are, if not unquestioned, presently considered more reliable than that of any other nation, the interest rate paid by these securities is considered the risk-free rate.  Since the US government is (ahem) very stable and trustworthy, and at any rate can always print more money to pay the bonds off, owning US Treasury securities is considered the safest investment one can make - the US government will always pay its debts.  The inflation resulting from more currency being printed in order to do so may destroy your return, but you'll always get your coupon and principal back, however little it's all worth at maturation.  With interest rates as low as they are at present, one could argue that US government bonds are a better example of reward-free risk than the inverse, but that's another topic.


The relative return analysis might be posed as follows: "If I can earn the 3% paid on the 30-year bond, what higher return do I need to be offered to own the relatively riskier bond of GM, or even riskier stock of IBM?"  All investment alternatives begin with this comparison to the risk-free rate; all risk is relative to that benchmark return.


The logic behind this is not unsound, but human beings are notoriously inept at gauging risk and reward.  To begin with, there's no such thing as a risk-free return.  The Federal Reserve and other financial authorities in the US operate with a huge cloud of moral hazard over their heads.  American history is replete with examples of monetary and fiscal policies that wreaked havoc on the valuation of the entire spectrum of asset classes, and on at least one occasion plunged the entire world into economic darkness. 


If this is the case, and the risk-free rate is anything but risk free, why even make reference to it?  Low interest rates are frequently accompanied by a significant increase in the money supply, which usually leads to inflation and the resulting erosion in the value of securities paying fixed interest, which the Federal Reserve eventually addresses by raising interest rates.  So, rates are lowered in order to spur an economy that is showing signs of slowing down, ultimately increasing the odds that inflation will erode the value of bonds and other interest-bearing securities, and for that one should accept a lower return rather than a higher one?


The answer is typically yes, because whether one likes it or not, if the goal is to own "ultra-safe" US Treasury securities, the rate they pay is the rate they pay - no negotiating.  But that doesn't mean that there is no choice, nor does it prohibit individual judgment.  It does not logically follow that simply because government securities offer a certain return that the equity investor should not expect a much higher return.  It's not clear that investors should generally even care what return government securities are offering.


The minimum return an investor expects is a question that should be asked in isolation,

not in reference to other securities.  Investing is an ad hoc process.


If the investor loses his entire investment because he owned stock in a company which went bankrupt, he won't care what the Treasury rate is or was.


Aim for 30%+ returns - compared to investing long-term in an index fund,

anything less simply isn't worth the added risk and effort.


For all the dangers inherent in owning a security that has the potential to be worthless even if the company has no debt, one should demand a prospective annualized return of at least 30%.  Remember: On top of the risk inherent in all equities, in every portfolio there has to be mistakes.  Start with a goal of 15%, add in a few poor judgment calls, and the investor is soon looking at single-digit returns.


30% is only approximately 2 times the rate of return on the S&P from 1965 through 1999.  This is important to note because there's no point in not investing in an index fund unless you intend to outperform that index by a significant margin.  Given all of the work entailed in exceeding that historical performance, intending to beat it by only a small margin is illogical.  The additional risk and personal opportunity cost aren't worth it, even taking into account the value of that additional return compounded over time - because that additional margin of performance also has to be repeated consistently for it to compound, no small challenge. 


Finally, consider the state of the market overall.  Many of the investors considered legends today are undeniably brilliant at what they do, but where were stock prices when they began investing?  It's a fact that there were some very rough years during the 1970s, for example, but any portfolio manager with a long track record today achieved that performance during the greatest bull market that the US has ever seen.  In the 1990s alone, the number of Americans owning stock swelled by 30 million to more than 80 million, a mania unseen since the 1920s.


Any investor starting in 2010 doesn't have that same wind at her back.  Even Warren Buffet performed better against the indices earlier on in his career.  Life has to be harder when the S&P is trading at 20 times earnings than it was at 7.5 times.  Going forward, because stocks are still trading well above the historical average, the downside risk is ever-present, and finding bargains is just that much more difficult.  Demand to be compensated adequately for taking that risk.


Limit Yourself

One way to help guarantee that only the best investment opportunities are pursued is to impose a limit on how many investments can be made per year.  On its face this might seem silly, but the frame of mind it induces is extremely helpful.


Imagine making only 7 investments per year.


The above seems like absurd advice, but imagine that it's only possible to make seven investments each year, literally.  With each investment made, a ticket is punched and there is one less opportunity to capture a return.  After those seven are used up, the only option is to sit on the sidelines and see how those investments perform.  How does this impact the investor's behavior?


She becomes incredibly choosy as to what she invests in - which is how she should be.


Taking the above literally poses some very real hazards.  What if eight attractive investments emerge in the space of a year?  The point is obviously not to haphazardly impose counterproductive limits on one's investing activity, but to adopt a level of scrutiny sufficiently demanding that only the very best investments are pursued.


Investing vs. Rational Speculation

Many adherents of the Warren Buffet / Graham-and-Dodd school of value investing see only one means for practicing that discipline: Buying attractive business through the purchase of shares (or bonds) and holding those securities over extended periods of time - the proverbial buy-and-hold approach.  However, it is central to my philosophy that there exists value investment opportunities that are not necessarily long-term ownership positions, but are attractive purely because the probability of outcome - the risk-reward relationship - is very favorable.  Both categories share the same basic framework for analysis:

Step 1: Valuation of the opportunity

Step 2: Calculation of the probability of that valuation being realized

One common example of this principle at work is merger arbitrage.  When the merger of two entities is announced, the price of the target company (as opposed to the acquirer) typically rises to a level almost, but not quite, equivalent to the buyer's offered price.  The discount to the offered price represents the degree of skepticism on the part of arbitrageurs, who speculate on such transactions, that the acquisition will fail or ultimately succeed.  If the discount is large enough, it may make sense to buy the shares; in the event the deal closes, the investor collects the discount as profit.

There are entire firms dedicated to speculating upon such transactions, and for those talented at forecasting the outcomes of these corporate events, purchasing the shares of target companies and collecting the discount as profit can be a very profitable and rational speculation.

The table below summarizes the differences between the two types of investing.


Typical Duration




Ownership claim on the future earnings

of an enterprise

Rational Speculation

Short-term Exploitation of the temporary price discrepancy of a security


As the table indicates, both categories have distinct timelines, or holding periods, as well as different reasons for pursuing them.  But both investments and rational speculations require the investor to determine the value of the opportunity as well as estimate the probability that such value will be realized.

Again, sound investing is ultimately about certainty of outcome and avoidance of financial harm, not simply "buy and hold"

On the one hand it would be very nice if there were a superabundance of investment opportunities which one could buy and blindly hold year after year.  But the effort to produce an attractive return sometimes leads one to promising opportunities for profit which are of a limited duration.  That doesn't mean that they are not sound, attractive values; it simply means that they're short-term opportunities rather than long-term investments.


The modern dean of value investing, Warren Buffet, would completely agree with the above paragraph.  In his letter to shareholders included in the Berkshire Hathaway 1988 annual report, Buffet included the following spin on the conventional wisdom: "Give a man a fish and you feed him for a day.  Teach him to arbitrage and you feed him forever."  Arbitrage is the iterative application of rational speculation which, if practiced soundly, is both profitable and conservative.  There are times when certain arbitrage strategies are more effective than others.  Merger arbitrage has for the better part of its history been cyclically profitable; when M&A activity is at its peak, dealflow typically exceeds arbitrage participation to an extent sufficient to produce attractive returns.  However, when M&A activity proceeds to tail off, the amount of capital looking to invest in those deals causes spreads to contract, making it a less profitable, more risky pursuit.


Regardless of how an investment might be categorized - merger arbitrage, value investment, "event" trade - what is absolutely critical is that one never confuse an investment with a rational speculation.  While both follow the same basic analytic path, investing in the future earnings of a company means that one is interested in being an owner of that enterprise.  Conversely, a short-term speculation, however rational, is an investment in a situation, not an entity.  The vehicle for that trade may be the ownership of an equity position in a company, but it wasn't purchased to effect ownership of the underlying business.


For example, a stock may be fairly valued at $25.  That is, $25 per share, along with whatever debt the company carries, is neither a bargain nor outlandish.  A news announcement causes the price to drop to $20 per share, but after thorough analysis one determines that the market has irrationally panicked because the news will have no impact on the underlying business.  The investor then purchases the stock, and two weeks later the stock is back trading near $25.  Because the investor bought the shares due to a short-term price discrepancy, he will sell the shares.  Without the event of the news, the investor was not interested in owning the business at the price of $25 because it presented no bargain.  For this reason, he sells the shares when the discrepancy dissipates.


Investment managers often get themselves into deep trouble by confusing the above two categories.  Referring again to the example above, imagine that the stock is actually quite overvalued at $25, but trades there very steadily.  The same news comes out and the stock drops to $20, and the buyer jumps in because the shares have overreacted.  But this time they don't trade back up near $25 - they drop to around $17.  All too often under these circumstances the investor conveniently disregards his initial reasoning and decides to hold the stock at $17 because it's a "great investment."  Suddenly he wants to be an owner of a business he wasn't remotely interested in owning at the outset.


 Beware of Rational Speculations (i.e., trades) that become Investments...


Probability Analysis

Regardless of whether one's position is an investment or a rational speculation, what is absolutely central to success is calculating a reliable probability of possible outcomes.  Taking into account all that is discussed in the Investment Analysis section of this website, a highly reliable projection of the future cash flows of a business can nonetheless be completely undermined by a faulty forecast of the probability of those cash flows coming to fruition.


While arriving at reliable probabilities can be challenging, reducing probabilities to financial outcomes is reasonably straightforward.  Consider the following question: What is a 50/50 chance of winning $1 worth?  The answer is $0.50 - this is calculated by multiplying the decimalization of 50%, or .50, times $1.  Logically, a 90% chance would be worth $0.90, leaving a downside risk of losing $0.10.  In calculating these outcomes, the percentage probabilities always add up 100%.


Value at Risk

% Chance

of Profit

% Chance of Loss Probability-adjusted Profit Probability-adjusted Loss



$100 50% 50% $50 - $50 1:1
$100 90% 10% $90 - $10 9:1
$100 30% 70% $30 - $70 3:7


The above assumes different profit/loss probabilities for the same value, $100.  However, investments often offer asymmetric returns.  Consider the following:


Potential Profit % Chance of Profit Probability-adjusted Profit Potential Loss % Chance of Loss Probability-adjusted Loss Net Profit/Loss



$100 50% $50 $300 50% - $150 $50 - $150 = $100 1:3
$200 80% $160 $400 20% - $80 $160 - $80 = $80 2:1


Note that in the second example immediately above the potential loss of $400 is much greater than the potential profit of $200, but because the probability of realizing that $200 profit is much higher, what seems like a risky investment isn't necessarily so, as reflected in the upside/downside ratio.  The above also confirms what was stated earlier: Even if the investment outcome is carefully calculated, the probability of that outcome must be just as deliberately discerned.  If not, what seems a solid investment can easily lead to disaster, and what appears on its surface risky can ultimately be a very intelligent, conservative investment.


Asset vs. Portfolio Diversification (Briefly)

Asset diversification isn't about how many investments are in a portfolio; it's about how much of one's net worth is invested.  Because security prices can sometimes fluctuate dramatically, it's important to not have too much of one's net worth invested in the financial markets.  Personal financial planning advice is not the purpose of this website, but it's an important point because over-investment drives poor decision-making.  Per the advice above regarding detachment and panic, the amount of net worth invested cannot be so large that individual investment decisions become personalized - i.e., when a stock drops the first thought one has is "How am I going to make my mortgage payment?" or "There went my vacation plans."  Provided adequate personal asset diversification, what is negative news for many others - prices plummeting - can be good news because patience, detachment, and adequate liquidity enable opportunistic buying.   


Exceptions to This Philosophy

I embrace this investment approach because, from beginning to end, it is transparently sensible to me and it has been very effective.  Having spent a number of years in the investment world, I am also aware of other very different approaches that have apparently been consistently profitable year after year.  One that comes to mind literally employs dozens of PhDs and utilizes extraordinarily sophisticated quantitative techniques.  I admire these operations for their attractive returns, but they're not a part of my sphere for several reasons:

1.  I don't understand them, and hence;


2.  I couldn't replicate them if I wanted to; and


3.  Even if I understood how to replicate them, I don't possess the resources to do so; and


4.  Even if I did, I already have a method for investing that makes eminent sense to me;



5.  Unlike those strategies, my methodology is not only straightforward and transparent, but the

     resources required to apply it are quite minimal.  One need only a telephone, a computer, an

     internet connection, and the willingness to do the work...