Margin of Safety

Individual and institutional investors alike frequently demonstrate an inability to make long-term investment decisions based on business fundamentals. There are a number of reasons for this: among them the performance pressures faced by institutional investors, the compensation structure of Wall Street, and the frenzied atmosphere of financial markets. As a result, investors, particularly institutional investors, become enmeshed in a short-term relative-performance derby, whereby temporary price fluctuations become the dominant focus. Relative-performance-oriented investors, already focused on short-term returns, frequently are attracted to the latest market fads as a source of superior relative performance. The temptation of making a fast buck is great, and many investors find it difficult to fight the crowd.

Ultimately investors must choose sides. One side—the wrong choice—is a seemingly effortless path that offers the comfort of consensus. This course involves succumbing to the forces that guide most market participants, emotional responses dictated by greed and fear and a short-term orientation emanating from the relative-performance derby. Investors following this road increasingly think of stocks as commodities to be bought and sold. This ultimately requires investors to spend their time guessing what other market participants may do and then trying to do it first.

The correct choice for investors is obvious but requires a level of commitment most are unwilling to make. This choice is known as fundamental analysis, whereby stocks are regarded as fractional ownership of the underlying business that they represent. One form of fundamental analysis is an investment approach known as value investing. Value investing is a stimulating, intellectually challenging, ever changing, and financially rewarding discipline.

There is nothing esoteric about value investing. It is simply the process of determining the value underlying a security and then buying it at a considerable discount from that value. It is really that simple. The greatest challenge is maintaining the requisite patience and discipline to buy only when prices are attractive and to sell when they are not, avoiding the short-term performance frenzy that engulfs most market participants.

The focus of most investors differs from that of value investors. Most investors are primarily oriented toward return—how much they can make—and pay little attention to risk—how much they can lose. Institutional investors, in particular, are usually evaluated—and therefore measure themselves—on the basis of relative performance compared to the market as a whole, to a relevant market sector, or to their peers.

Value investors, by contrast, have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical erroring in order to avoid sizable losses over time. 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.

If investors could predict the future direction of the market, they would certainly not choose to be value investors all the time. Indeed, when securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public’s favorites. When the market becomes fully valued on its way to being overvalued, value investors again fare poorly because they sell too soon.

The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism. Value investors invest with a margin of safety that protects them from large losses in declining markets.

Those who can predict the future should participate fully, indeed on margin using borrowed money, when the market is about to rise and get out of the market before it declines. Unfortunately, many more investors claim the ability to foresee the market’s direction than actually possess that ability. Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments.

The value discipline seems simple enough but is apparently a difficult one for most investors to grasp or adhere to. As Buffett has often observed, value investing is not a concept that can be learned and applied gradually over time. It is either absorbed and adopted at once, or it is never truly learned. Once you adopt a value-investment strategy, any other investment behavior starts to seem like gambling.

Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own analysis and judgment, they respond to market forces not with blind emotion but with calculated reason. Successful investors, for example, demonstrate caution in frothy markets and steadfast conviction in panicky ones. Indeed, the very way an investor views the market and its price fluctuations is a key factor in his or her ultimate investment success or failure.

Those who choose investment over speculation are faced with another choice, this time between two opposing views of the financial markets. One view, widely held among academics and increasingly among institutional investors, is that the financial markets are efficient and that trying to outperform the averages is futile. Matching the market return is the best you can hope for. Those who attempt to outperform the market will incur high transaction costs and taxes, causing them to underperform instead.

The other view is that some securities are inefficiently priced, creating opportunities for investors to profit with low risk. This view was perhaps best expressed by Benjamin Graham, who posited the existence of a Mr. Market. An ever helpful fellow, Mr. Market stands ready every business day to buy or sell a vast array of securities in virtually limitless quantities at prices that he sets. He provides this valuable service free of charge. Sometimes Mr. Market sets prices at levels where you would neither want to buy nor sell. Frequently, however, he becomes irrational. Sometimes he is optimistic and will pay far more than securities are worth. Other times he is pessimistic, offering to sell securities for considerably less than underlying value. Value investors—who buy at a discount from underlying value—are in a position to take advantage of Mr. Market’s irrationality.

Some investors—really speculators—mistakenly look to Mr. Market for investment guidance. They observe him setting a lower price for a security and, unmindful of his irrationality, rush to sell their holdings, ignoring their own assessment of underlying value. Other times they see him raising prices and, trusting his lead, buy in at the higher figure as if he knew more than they. The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals. Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market’s periodic irrationality, by contrast, have a good chance of enjoying long-term success.

Mr. Market’s daily fluctuations may seem to provide feedback for investors’ recent decisions. For a recent purchase decision rising prices provide positive reinforcement; falling prices, negative reinforcement. If you buy a stock that subsequently rises in price, it is easy to allow the positive feedback provided by Mr. Market to influence your judgment. You may start to believe that the security is worth more than you previously thought and refrain from selling, effectively placing the judgment of Mr. Market above your own. You may even decide to buy more shares of this stock, anticipating Mr. Market’s future movements. As long as the price appears to be rising, you may choose to hold, perhaps even ignoring deteriorating business fundamentals or a diminution in underlying value.

Similarly, when the price of a stock declines after its initial purchase, most investors, somewhat naturally, become concerned. They start to worry that Mr. Market may know more than they do or that their original assessment was in error. It is easy to panic and sell at just the wrong time. Yet if the security were truly a bargain when it was purchased, the rational course of action would be to take advantage of this even better bargain and buy more.

Louis Lowenstein has warned us not to confuse the real success of an investment with its mirror of success in the stock market. The fact that a stock price rises does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in underlying value. Likewise, a price fall in and of itself does not necessarily reflect adverse business developments or value deterioration.

It is vitally important for investors to distinguish stock price fluctuations from underlying business reality. If the general tendency is for buying to beget more buying and selling to precipitate more selling, investors must fight the tendency to capitulate to market forces. You cannot ignore the market—ignoring a source of investment opportunities would obviously be a mistake—but you must think for yourself and not allow the market to direct you. Value in relation to price, not price alone, must determine your investment decisions. If you look to Mr. Market as a creator of investment opportunities (where price departs from underlying value), you have the makings of a value investor. If you insist on looking to Mr. Market for investment guidance, however, you are probably best advised to hire someone else to manage your money.

Security prices move up and down for two basic reasons: to reflect business reality (or investor perceptions of that reality) or to reflect short-term variations in supply and demand. Reality can change in a number of ways, some company-specific, others macroeconomic in nature. If Coca-Cola’s business expands or prospects improve and the stock price increases proportionally, the rise may simply reflect an increase in business value. On a macroeconomic level a broad-based decline in interest rates, a drop in corporate tax rates, or a rise in the expected rate of economic growth could each precipitate a general increase in security prices.

Security prices sometimes fluctuate, not based on apparent changes in reality, but on changes in investor perception. In the short run supply and demand alone determine market prices. If there are many large sellers and few buyers, prices fall, sometimes beyond reason. Supply-and-demand imbalances can result from year-end tax selling, an institutional stampede out of a stock that just reported disappointing earnings, or an unpleasant rumor. Most day-to-day market price fluctuations result from supply-and-demand variations rather than from fundamental developments.

Investors will frequently not know why security prices fluctuate. They may change because of, in the absence of, or in complete indifference to changes in underlying value. In the short run investor perception may be as important as reality itself in determining security prices. It is never clear which future events are anticipated by investors and thus already reflected in today’s security prices. Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.

Unsuccessful investors are dominated by emotion. Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear. 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.

High levels of greed sometimes cause new-era thinking to be introduced by market participants to justify buying or holding overvalued securities. Reasons are given as to why this time is different from anything that came before. As the truth is stretched, investor behavior is carried to an extreme. Conservative assumptions are revisited and revised in order to justify ever higher prices, and a mania can ensue. In the short run resisting the mania is not only psychologically but also financially difficult as the participants make a lot of money, at least on paper. Then, predictably, the mania reaches a peak, is recognized for what it is, reverses course, and turns into a selling panic. Greed gives way to fear, and investor losses can be enormous. There are countless examples of investor greed in recent financial history.

Many investors greedily persist in the investment world’s version of a search for the holy grail: the attempt to find a successful investment formula. It is human nature to seek simple solutions to problems, however complex. Given the complexities of the investment process, it is perhaps natural for people to feel that only a formula could lead to investment success.

Just as many generals persist in fighting the last war, most investment formulas project the recent past into the future. Some investment formulas involve technical analysis, in which past stock-price movements are considered predictive of future prices. Other formulas incorporate investment fundamentals such as price-to-earnings ratios, price-to-book-value ratios, sales or profits growth rates, dividend yields, and the prevailing level of interest rates. Despite the enormous effort that has been put into devising such formulas, none has been proven to work.

One simplistic, backward-looking formula employed by some investors is to buy stocks with low P/E ratios. The idea is that by paying a low multiple of earnings, an investor is buying an out-of-favor bargain. In reality investors who follow such a formula are essentially driving by looking only in the rear-view mirror. Stocks with a low P/E ratio are often depressed because the market price has already discounted the prospect of a sharp fall in earnings. Investors who buy such stocks may soon find that the P/E ratio has risen because earnings have declined.

The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula could be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. The quest for a formula that worked would then begin anew. Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific investment opportunities.

The financial markets offer many temptations to vulnerable investors. It is easy to do the wrong thing, to speculate rather than invest. Emotion lies dangerously close to the surface for most investors and can be particularly intense when market prices move dramatically in either direction. It is crucial that investors understand the difference between speculating and investing and learn to take advantage of the opportunities presented by Mr. Market.

When a particular sector is in vogue, success is a self-fulfilling prophecy. As buyers bid up prices, they help to justify their original enthusiasm. When prices peak and start to decline, however, the downward movement can also become self-fulfilling. Not only do buyers stop buying, they actually become sellers, aggravating the oversupply problem that marks the peak of every fad.

Sometimes companies selling a trendy product (i.e. home shopping in the 1980s) will achieve a lofty level of valuation that can be justified only under the most optimistic assumptions of revenue growth, profitability, and future business value. However, the value of the company depends on the profitability of the product, the product life cycle, competitive barriers, and the ability of the company to replicate its current success. Investors are often overly optimistic about the sustainability of a trend, the ultimate degree of market penetration, and the size of profit margin.

All market fads come to an end. Security prices eventually become too high, supply catches up with and then exceeds demand, the top is reached, and the downward slide ensues. There will always be cycles of investment fashion and just as surely investors who are susceptible to them.

It is only fair to note that it is not easy to distinguish an investment fad from a real business trend. Indeed, many investment fads originate in real business trends, which deserve to be reflected in stock prices. The fad becomes dangerous, however, when share prices reach levels that are not supported by the conservatively appraised values of the underlying businesses.

Warren Buffett likes to say that the first rule of investing is “Don’t lose money,” and the second rule is, “Never forget the first rule.” Avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather “don’t lose money” means that over several years an investment portfolio should not be exposed to appreciable loss of principal.

While no one wishes to incur losses, you couldn’t prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest “hot” IPO. Yet the avoidance of loss is the surest way to ensure a profitable outcome.

A loss-avoidance strategy is at odds with recent conventional market wisdom. Today many people believe that risk comes, not from owning stocks, but from not owning them. Stocks as agroup, this line of thinking goes, will outperform bonds or cash equivalents over time, just as they have in the past. Indexing is one manifestation of this view. The tendency of most institutional investors to be fully invested at all times is another.

There is an element of truth to this notion; stocks do figure to outperform bonds and cash over the years. Being junior in a company’s capital structure and lacking contractual cash flows and maturity dates, equities are inherently riskier than debt instruments. In a corporate liquidation, for example, the equity only receives the residual after all liabilities are satisfied. To persuade investors to venture into equities rather than safer debt instruments, they must be enticed by the prospect of higher returns. However, the actual risk of a particular investment cannot be determined from historical data. It depends on the price paid. If enough investors believe the argument that equities will offer the best long-term returns, they may pour money into stocks, bidding prices up to levels at which they no longer offer the superior returns. The risk of loss stemming from equity’s place in the capital structure is exacerbated by paying a higher price.

Another common belief is that risk avoidance is incompatible with investment success. This view holds that high return is attainable only by incurring high risk and that long-term investment success is attainable only by seeking out and bearing, rather than avoiding, risk. Why is risk avoidance the single most important element of an investment program? If you had $1,000, would you be willing to wager it, double or nothing, on a fair coin toss? Probably not. Would you risk your entire net worth on such a gamble? Of course not. Would you risk the loss of, say, 30% of your net worth for an equivalent gain? Not many people would because. The loss of a substantial amount of money could impair their standard of living while a comparable gain might not improve it commensurately. If you are one of the vast majority of investors who are risk averse, then loss avoidance must be the cornerstone of your investment philosophy.

Greedy, short-term-oriented investors may lose sight of a sound mathematical reason for avoiding loss: the effects of compounding even moderate returns over many years are compelling, if not downright mind boggling. The table below shows the delightful effects of compounding even relatively small amounts.

As the table illustrates, perseverance at even relatively modest rates of return is of the utmost importance in compounding your net worth. A corollary to the importance of compounding is that it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal. An investor who earns 16% annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20% a year for nine years and then loses 15% the tenth year.

There is an understandable, albeit uneconomic, appeal to the latter pattern of returns, however. The second investor with outperform the former nine years out of ten, gaining considerable psychic income from his apparently superior performance. If both investors are money management professionals, the latter may also have a happier clientele (90% of the time, they will be doing better) and thus a more successful company. This may help to explain why risk avoidance is not the primary focus of most institutional investors.

The future is unpredictable. No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survive and even prosper under any circumstances. Bad luck can befall you; mistakes happen. The river may overflow its banks only once or twice in a century, but you still buy flood insurance on your house each year. Similarly, we may only have one or two economic depressions or financial panics in a century and hyperinflation may never ruin the U.S. economy, but the prudent, farsighted investor manages his or her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.

Choosing to avoid loss is not a complete investment strategy; it says nothing about what to buy and sell, about which risks are acceptable and which are not. A loss-avoidance strategy does not mean that investors should hold all or even half of their portfolios in U.S. Treasury bills or own sizable caches of gold bullion. Rather, investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different form the present or recent past. Investors must be prepared for any eventuality.

Many investors mistakenly establish an investment goal of achieving a specific rate of return. Setting a goal, unfortunately, does not make that return achievable. Indeed, no matter what the goal, it may be out of reach. Stating tht you want to earn, say, 15% a year, does not tell you a thing about how to achieve it. Investment returns are not a direct function of how long or hard you work or how much you wish to earn. A ditch digger can work an hour of overtime for extra pay, and a piece worker earns more the more he or she produces. An investor cannot decide to think harder or put in overtime in order to achieve a higher return. All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come.

Targeting investment returns leads investors to focus on upside potential rather than on downside risk. Depending on the level of security prices, investors may have to incur considerable downside risk to have a chance of meeting predetermined return objectives. If Treasury bills yield 6%, more cannot be achieved from owning them. If thirty-year government bonds yield 8%, it is possible, for a while, to achieve a 15% annual return through capital appreciation resulting from a decline in interest rates. If the bonds are held to maturity, however, the return will be 8%.

Stocks do not have the firm mathematical tether afforded by the contractual nature of the cash flows of a high-grade bond. Stocks, for example, have no maturity date or price. Moreover, while the value of a stock is ultimately tied to the performance of the underlying business, the potential profit from owning a stock is much more ambiguous. Specifically, the owner of a stock does not receive the cash flows from a business; he or she profits from appreciation in the share price, presumably as the market incorporates fundamental business developments into that price. Investors thus tend to predict their returns from investing in equities by predicting future stock prices. Since stock prices do not appreciate in a predictable fashion but fluctuate unevenly over time, almost any forecast can be made and justified. It is thus possible to predict the achievement of any desired level of return simply by fiddling with one’s estimate of future share prices.

In the long run, however, stock prices are also tethered, albeit more loosely than bonds, to the performance of the underlying businesses. If the prevailing stock price is not warranted by underlying value, it will eventually fall. Those who bought in at a price that itself reflected overly optimistic assumptions will incur losses.

Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate. Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.

Most investment approaches do not focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Value investing does.

Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is the key to the process. In the language of value investors, this is referred to as buying a dollar for fifty cents. Value investing combines the conservative analysis of underlying value with the requisite discipline and patience to buy only when a sufficient discount from that value is available. The number of available bargains varies, and the gap between the price and value of any given security can be very narrow or extremely wide. Sometimes a value investor will review in depth a great many potential investments without finding a single one that is sufficiently attractive. Such persistence is necessary, however, since value is often well hidden.

The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline. Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds. It can be a very lonely undertaking. A value investor may experience poor, even horrendous, performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation. Yet over the long run the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it.

Warren Buffett uses a baseball analogy to articulate the discipline of value investors. A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated only by their own results. They have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.

Value investors will not invest in businesses that they cannot readily understand or ones they find excessively risky. Hence few value investors will own the shares of technology companies. Many also shun commercial banks, which they consider to have unanalyzable assets, as well as property and casualty insurance companies, which have both unanalyzable assets and liabilities.

Most institutional investors, unlike value investors, feel compelled to be fully invested at all times. They act as if an umpire were calling balls and strikes—mostly strikes—thereby forcing them to swing at almost every pitch and forego battling selectivity for frequency. Many individual investors, like amateur ballplayers, simply can’t distinguish a good pitch from a wild one. Both undiscriminating individuals and constrained institutional investors can take solace from knowing that most market participants feel compelled to swing just as frequently as they do.

For a value investor a pitch must not only be in the strike zone, it must be in his “sweet spot.” Results will be best when the investor is not pressured to invest prematurely. There may be times when the investor does not lift the bat from his shoulder; the cheapest security in an overvalued market may still be overvalued. You wouldn’t want to settle for an investment offering a safe 10% return if you thought it very likely that another offering an equally safe 15% return would soon materialize.

An investment must be purchased at a discount from underlying worth. This makes it a good absolute value. Being a good absolute value alone, however, is not sufficient for investors must choose only the best absolute values among those that are currently available. A stock trading at one-half its underlying value may be attractive, but another trading at one-fourth of its worth is the better bargain. This dual discipline compounds the difficulty of the investment task for value investors compared with most others.

Value investors continually compare potential new investments with their current holdings in order to ensure that they own only the most undervalued opportunities available. Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings. In other words, no investment should be considered sacred when a better one comes along.

Sometimes dozens of good pitches are thrown consecutively to a value investor. In panicky markets, for example, the number of undervalued securities increases and the degree of undervaluation also grows. In buoyant markets, by contrast, both the number of undervalued securities and their degree of undervaluation declines. When attractive opportunities are plentiful, value investors are able to sift carefully through all the bargains for the ones they find most attractive. When attractive opportunities are scarce, however, investors must exhibit great self-discipline in order to maintain the integrity of the valuation process and limit the price paid. Above all, investors must always avoid swinging at bad pitches.

It would be a serious mistake to think that all the facts. That describe a particular investment are or could be known. Not only may questions remain unanswered; all the right questions may not even have been asked. Even if the present could somehow be perfectly understood, most investments are dependent on outcomes that cannot be accurately foreseen.

Even if everything could be known about an investment, the complicating reality is that business values are not carved in stone. Investing would be much simpler if business values did remain constant while stock prices revolved predictably around them like the planets around the sun. If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot.

There are many explanations for volatility in business value. The “credit cycle,” the periodic tightening and relaxation of the availability of credit, is a major factor, for example, because it influences the cost and terms upon which money can be borrowed. This in turn affects the multiples that buyers are willing to pay for businesses. Simply put, buyers will willingly pay higher multiples if they receive low-rate nonrecourse financing than they will in an unleveraged transaction.

Trends in inflation or deflation also cause business values to fluctuate. That said, value investing can work very well in an inflationary environment. If for fifty cents you buy a dollar of value in the form of an asset, such as natural resource properties or real estate, which increases in value with inflation, a fifty-cent investment today can result in the realization of value appreciably greater than one dollar. In an inflationary environment, however, investors may become somewhat careless. As long as assets are rising in value, it would appear attractive to relax one’s standards and purchase $1 of assets, not for 50 cents, but for 70 or 80 cents (or perhaps even $1.10). Such laxity could prove costly, however, in the event that inflation comes to be anticipated by most investors, who respond by bidding up security prices. A subsequent slowdown in the rate of inflation could cause a price decline.

In a deflationary environment, assets tend to decline in value. Buying a dollar’s worth of assets for fifty cents may not be a bargain if the asset value is dropping. Historically investors have found attractive opportunities in companies with substantial “hidden assets,” such as an overfunded pension fund, real estate carried on the balance sheet below market value, or a profitable finance subsidiary that could be sold at a significant gain. Amidst a broad-based decline in business and asset values, however, some hidden assets become less valuable and, in some cases, may become hidden liabilities. A decline in the stock market will reduce the value of pension fund assets; previously overfunded plans may become underfunded. Real estate, carried on companies’ balance sheets at historical cost, may no longer be undervalued. Overlooked subsidiaries that were once hidden jewels may lose their luster.

The possibility of sustained decreases in business value is a dagger at the heart of value investing (and is not a barrel of laughs for other investment approaches either). Value investors place great faith in the principle of assessing value and then buying at a discount. If value is subject to considerable erosion, then how large a discount is sufficient?

Should investors worry about the possibility that business value may decline? Absolutely. Should they do anything about it? There are three responses that might be effective. First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods. Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions. This means that normally selective investors would probably let even more pitches than usual go by. Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause value to diminish become moot.

Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future. He also understood that he might be wrong about today’s value. Therefore, Graham had no interest in paying $1 for $1 of value. There was no advantage in doing so, and losses could result. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.

Because investing as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world. According to Graham, “The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price.”

Buffett described the margin of safety concept in terms of tolerances: “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”

What is the requisite margin of safety for an investor? The answer can vary from one investor to the next. How much bad luck are you willing and able to tolerate? How much volatility in business values can you absorb? What is your tolerance for error? It comes down to how much you can afford to lose.

Most investors do not seek a margin of safety in their holdings. Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve a margin of safety. Greedy individual investors who follow market trends and fads are in the same boat.

Even among value investors there is ongoing disagreement concerning the appropriate margin safety. Some highly successful investors, including Buffett, have come increasingly to recognize the value of intangible assets—broadcast licenses or soft-drink formulas, for example—which have a history of growing in value without any investment being required to maintain them. Virtually all cash flow generated is free cash flow.

The problem with intangible assets is that they hold little or no margin of safety. The most valuable assets of Dr Pepper/Seven-Up, Inc., by way of example, are the formulas that give those soft drinks their distinctive flavors. It is these intangible assets that cause Dr Pepper/Seven-Up, Inc., to be valued at a high multiple of tangible book value. If something goes wrong—tastes change or a competitor makes inroads—the margin of safety is quite low.

Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection form loss. Tangible assets usually have value in alternative uses, thereby providing a margin of safety. If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, receivables collected, leases transferred, and real estate sold. If consumers lose their taste for Dr Pepper, by contrast, tangible assets will not meaningfully cushion investors’ losses.

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. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.). By replacing current holdings as better bargains come along. By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.

Investors should pay attention not only to whether but also to why current holdings are undervalued. It is critical to know why you have made an investment and to sell when the reason for owning it no longer applies. Look for investments with catalysts that may assist directly in the realization of underlying value. Give preference to companies having good managements with a personal financial stake in the business. Finally, diversify your holdings and hedge when it is financially attractive to do so.

When the overall market is strong, the rising tide lifts most ships. Profitable investments are easy to come by, mistakes are not costly, and high risks seem to pay off, making them seem reasonable in retrospect. As the saying goes, “You can’t tell who’s swimming naked till the tide goes out.”

A market downturn is the true test of an investment philosophy. Securities that have performed well in a strong market are usually those for which investors have had the highest expectations. When these expectations are not realized, the securities, which typically have no margin of safety, can plummet. Stocks that fit this description are sometimes referred to as “torpedo stocks,” a term that describes the disastrous effect owning them can have on one’s investment results.

The securities owned by value investors are not buoyed by such high expectations. To the contrary, they are usually unheralded or just ignored. In depressed financial markets, it is said, some securities are so out of favor that you cannot give them away. Some stocks sell below net working capital per share, and a few sell at less than net cash (cash on hand less all debt) per share; many stocks trade at an unusually low multiple of current earnings and cash flow and at a significant discount to book value.

A notable feature of value investing is its strong performance in periods of overall market decline. Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor’s margin of safety is high. Stock and bond prices may anticipate continued poor business results, yet securities priced to reflect those depressed fundamentals may have little room to fall further. Moreover, securities priced as if nothing could go right stand to benefit from a change in perception. If investors refocused on the strengths rather than on the difficulties, higher security prices would result. When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them.

Investors should understand not only what value investing is but also why it is a successful investment philosophy. At the very core of its success is the recurrent mispricing of securities in the marketplace. Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong. If, on the one hand, securities can become undervalued or overvalued, value investors will thrive. If, on the other hand, all securities at some future date become fairly and efficiently priced, value investors will have nothing to do. It is important, then, to consider whether or not the financial markets are efficient.

The efficient market hypothesis takes three forms. The weak form maintains that past stock prices provide no useful information on the future direction of stock prices. In other words, technical analysis (analysis of past price fluctuation) cannot help investors. The semistrong form says that no published information will help investors to select undervalued securities since the market has already discounted all publicly available information into securities prices. The strong form maintains that there is no information, public or private, that would benefit investors. The implication of both the semi-strong and strong forms is that fundamental analysis is useless. Investors might just as well select stocks at random.

Of the three forms of the efficient-market hypothesis, Seth Klarman believes that only the weak form is valid—technical analysis is a waste of time. As to the other forms: yes, the market does tend to incorporate new information into prices—securities prices are neither random nor do they totally ignore available information—yet the market is far from efficient. There is simply no question that investors applying disciplined analysis can identify inefficiently priced securities, buy and sell accordingly, and achieve superior returns. Specifically, by finding securities whose prices depart appreciably from underlying value, investors can frequently achieve above-average returns while taking below-average risks.

The pricing of large-capitalization stocks tends to be more efficient than that of small-capitalization stocks, distressed bonds, and other less-popular investment fare. While hundreds of investment analysts follow IBM, few, if any, cover thousands of small-capitalization stocks and obscure junk bonds. Investors are more likely, therefore, to find inefficiently priced securities outside the Standard and Poor’s 100 than within it. Even among the most highly capitalized issues, however, investors are frequently blinded by groupthink, thereby creating pricing inefficiencies.

Is it reasonable to expect that in the future some securities will continue to be significantly mispriced from time to time? Probably. The elegance of the efficient-market theory is at odds with the reality of how the financial markets operate.

Why do stock prices tend to depart from underlying value, thereby making the financial markets inefficient? There are numerous reasons, the most obvious being that securities prices are determined in the short run by supply and demand. The forces of supply and demand do not necessarily correlate with value at any given time. Also, many buyers and sellers of securities are motivated by considerations other than underlying value and may be willing to buy or sell at very different prices than a value investor would.

If a stock is part of a major market index, for example, there will be demand from index funds to buy it regardless of whether it is overpriced in relation to underlying value. Similarly, if a stock has recently risen on increasing volume, technical analysts might consider it attractive; by definition, underlying value would not be a part of their calculations. If a company has exhibited rapid recent growth, it may trade at a “growth” multiple, far higher than a value investor would pay. Conversely, a company that recently reported disappointing results might be dumped by investors who focused exclusively on earnings, depressing the price to a level considerably below underlying value. An investor unable to meet a margin call is in no position to hold out for full value; he or she is forced to sell at the prevailing market price.

The behavior of institutional investors, dictated by constraints on their behavior, can sometimes cause stock prices to depart from underlying value. Institutional selling of a low-priced small-capitalization spinoff, for example, can cause a temporary supply-demand imbalance, resulting in a security becoming undervalued. If a company fails to declare an expected dividend, institutions restricted to owning only dividend-paying stocks may unload the shares. Bond funds allowed to own only investment-grade debt would dump their holdings of an issue immediately after it was downgraded below BBB by the rating agencies. Such phenomena as year-end tax selling and quarterly window dressing can also cause market inefficiencies, as value considerations are subordinated to other factors.

Benjamin Graham and David Dodd explained stock mispricings this way: “The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities… The market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.”

A central tenet of value investing is that over time the general tendency is for underlying value either to be reflected in securities prices or otherwise realized by shareholders. This does not mean that in the future stock prices will exactly equal underlying value. Some securities are always moving away from underlying value, while others are moving closer, and any given security is likely to be both undervalued and overvalued as well as fairly valued within its lifetime. The long-term expectation, however, is for the prices of securities to move toward underlying value.

Of course, securities are rarely priced in complete disregard of underlying value. Many of the forces that cause securities prices to depart from underlying value are temporary. In addition, there are a number of forces that help bring security prices into line with underlying value. Management prerogatives such as share issuance or repurchase, subsidiary spinoffs, recapitalizations, and, as a last resort, liquidation or sale of the business all can serve to narrow the gap between price and value. External forces such as hostile takeovers and proxy fights may also serve as catalysts to correct price/value disparities. In a sense, value investing is a large-scale arbitrage between security prices and underlying business value. Arbitrage is a means of exploiting price differentials between markets. Unlike classic arbitrage, however, value investing is not risk-free; profits are neither instantaneous nor certain.

“Value investing” is one of the most overused and inconsistently applied terms in the investment business. A broad range of strategies make use of value investing as a pseudonym. Many have little or nothing to do with the philosophy of investing originally espoused by Graham. The misuse of the value labeled accelerated in the mid-1980s in the wake of increasing publicity given to the long-term success of true value investors such as Warren Buffett, Michael Price and Max Heine, and William Ruane and Richard Cunniff, among others. Their results attracted a great many “value pretenders,” investment chameleons who frequently change strategies in order to attract funds to manage.

These value pretenders are not true value investors, discipline craftspeople who understand and accept the wisdom of the value approach. Rather they are charlatans who violate the conservative dictates of value investing, using inflated business valuations, overpaying for securities, and failing to achieve a margin of safety for their clients. These investors, despite (or perhaps as a direct result of) their imprudence, are able to achieve good investment results in times of rising markets. When business valuations return to historical levels, however, most value pretenders will suffer substantial losses.

To some extent value, like beauty, is in the eye of the beholder; virtually any security may appear to be a bargain to someone. It is hard to prove an overly optimistic investor wrong in the short run since value is not precisely measurable and since stocks can remain overvalued for a long time. Accordingly, the buyer of virtually any security can claim to be a value investor at least for a while.

Value investing is simple to understand but difficult to implement. Value investors are not super-sophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing.

There are three central elements to a value-investment philosophy. First, value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities. Second, value investing is absolute-performance, not relative-performance oriented. Finally, value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return).

A great many professional investors employ a top-down approach. This involves making a prediction about the future, ascertaining its investment implications, and then acting upon them. This approach is difficult and risky, being vulnerable to error at every step. Practitioners need to accurately forecast macroeconomic conditions and then correctly interpret their impact on various sectors of the overall economy, on particular industries, and finally on specific companies. As if that were not complicated enough, it is also essential for top-down investors to perform this exercise quickly as well as accurately, or others may get there first and, through their buying or selling, cause prices to reflect the forecast macroeconomic developments, thereby eliminating the profit potential for latecomers.

The top-down investor thus faces the daunting task of predicting the unpredictable more accurately and faster than thousands of other bright people, all of them trying to do the same thing. It is not clear whether top-down investing is a greater-fool game, in which you win only when someone else overpays, or a greater-genius game, winnable at best only by those few who regularly possess superior insight. In either case, it is not an attractive game for risk-averse investors.

There is no margin of safety in top-down investing. Top-down investors are not buying based on value; they are buying based on a concept, theme, or trend. There is no definable limit to the price they should pay, since value is not part of their purchase decision. It is not even clear whether top-down-oriented buyers are investors or speculators. If they buy shares in businesses that they truly believe will do well in the future, they are investing. If they buy what they believe others will soon be buying, they may actually be speculating.

Another difficulty with a top-down approach is gauging the level of expectations already reflected in a company’s current share price. If you expect a business to grow 10% a year based on your top-down forecast and buy its stock betting on that growth, you could lose money if the market price reflects investor expectations of 15% growth but a lower rate is achieved. The expectations of others must therefore be considered as part of any top-down investment decision.

By contrast, value investing employs a bottom-up strategy by which individual investment opportunities are identified one at a time through fundamental analysis. Value investors search for bargains security by security, analyzing each situation on its own merits. An investor’s top-down views are considered only insofar as they affect the valuation of securities.

Paradoxically a bottom-up strategy is in many ways simpler to implement than a top-down one. While a top-down investor must make several accurate predictions in a row, a bottom-up investor is not in the forecasting business at all. The entire strategy can be concisely described as “buy a bargain and wait.” Investors must learn to assess value in order to know a bargain when they see one. Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large.

One significant and not necessarily obvious difference between a bottom-up and top-down strategy is the reason for maintain cash balances at times. Bottom-up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when such opportunities appear. A bottom-up investor chooses to be fully invested only when a diversified portfolio of attractive investments is available. Top-down investors, by contrast, may attempt to time the market, something bottom-up investors do not do. Market timing involves making a judgment about the overall market direction; when top-down investors believe the market will decline, they sell stocks to hold cash, awaiting a more bullish opinion.

Another difference between the two approaches is that bottom-up investors are able to identify simply and precisely what they are betting on. The uncertainties they face are limited: what is the underlying business worth; will that underlying value endure until shareholders can benefit from its realization; what is the likelihood that the gap between price and value will narrow; and, given the current market price, what is the potential risk and reward?

Bottom-up investors can easily determine when the original reason for making an investment ceases to be valid. When the underlying value changes, when management reveals itself to be incompetent or corrupt, or when the price appreciates to more fully reflect underlying business value, a disciplined investor can reevaluate the situation and, if appropriate, sell the investment, huge sums have been lost by investors who have held on to securities after the reason for owning them is no longer valid. In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.

Top-down investors, by contrast, may find it difficult to know when their bet is no longer valid. If you invest based on a judgment that interest rates will decline but they rise instead, how and when do you decide that you were wrong? Your bet may eventually prove correct, but then again it may not. Unlike judgments about value that can easily be reaffirmed, the possible grounds for reversing an investment decision that was made based upon a top-down prediction of the future are simply not clear.

Next: adopt an absolute-performance orientation. Most institutional and many individual investors have adopted a relative-performance orientation. They invest with the goal of outperforming either the market, other investors, or both and are apparently indifferent as to whether the results achieved represent an absolute gain or loss. Good relative performance, especially short-term relative performance, is commonly sought either by imitating what others are doing or by attempting to outgess what others will do. Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that become more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance. Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.

One significant difference between an absolute- and relative-performance orientation is evident in the different strategies for investing available cash. Relative-performance-oriented investors will typically choose to be fully invested at all times, since cash balances would likely cause them to lag behind a rising market. Since the goal is at least to match and optimally beat the market, any cash that is not promptly spent on specific investments must nevertheless be invested in a market-related index.

Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available. Cash is liquid and provides a modest, sometimes attractive nominal return, usually above the rate of inflation. The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs. Finally, unlike any other holding, cash does not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines.

Third: risk and return. While most other investors are preoccupied with how much money they can make and not at all with how much they may lose, value investors focus on risk as well as return. To the extent that most investors think about risk at all, they seem confused about it. Some insist that risk and return are always positively correlated; the greater the risk, the greater the return. This is, in fact, a basic tenet of the capital-asset-pricing model taught in nearly all business schools, yet it is not always true. Others mistakenly equate risk with volatility, emphasizing the “risk” of security price fluctuations while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments.

A positive correlation between risk and return would hold consistently only in an efficient market. Any disparities would be immediately corrected; this is what would make the market efficient. In inefficient markets it is possible to find investments offering high returns with low risk. These arise when information is not widely available, when an investment is particularly complicated to analyze, or when investors buy and sell for reasons unrelated to value. It is also commonplace to discover high-risk investments offering low returns. Overpriced and therefore risky investments are often available because the financial markets are biased toward overvaluation and because it is difficult for market forces to correct an overvalued condition if enough speculators persist in overpaying. Also, unscrupulous operators will always make overpriced investments available to anyone willing to buy; they are not legally required to sell at a fair price.

Since the financial markets are inefficient a good deal of the time, investors cannot simply select a level of risk and be confident that it will be reflected in the accompanying returns. Risk and return must instead be assessed independently for every investment.

In point of fact, greater risk does not guarantee greater return. To the contrary, risk erodes return by causing losses. It is only when investors shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than full compensates for the risk incurred. By itself risk does not create incremental return; only price can accomplish that.

The risk of an investment is described by both the probability and the potential amount of loss. The risk of an investment—the probability of an adverse outcome—is partly inherent in its very nature. A dollar spent on biotechnology research is a riskier investment than a dollar used to purchase utility equipment. The former has both a greater probability of loss and a greater percentage of the investment at stake.

In the financial markets, however, the connection between a marketable security and the underlying business is not as clearcut. For investors in a marketable security the gain or loss associated with the various outcomes is not totally inherent in the underlying business; it also depends on the price paid, which is established by the marketplace. The view that risk is dependent on both the nature of investments and on their market price is very different from that described by beta.

While security analysts attempt to determine with precision the risk and return of investments, events alone accomplish that. For most investments the amount of profit earned can be known only after maturity or sale. Only for the safest of investments is return knowable at the time of purchase: a one-year 6% T-bill returns 6% at the end of one year. For riskier investments the outcome must be known before the return can be calculated. If you buy one hundred shares of Chrysler Corporation, for example, your return depends almost entirely on the price at which it is trading when you sell. Only then can the return be calculated.

Unlike return, however, risk, is no more quantifiable at the end of an investment than it was at its beginning. Risk simply cannot be described by a single number. Intuitively we understand that risk varies from investment to investment: a government bond is not as risky as the stock of a high-technology company. But investments do not provide information about their risks the way food packages provide nutritional data.

Rather, risk is a perception in each investor’s mind that results from analysis of the probability and amount of potential loss from an investment. If an exploratory oil well proves to be a dry hole, it is called risky. If a bond defaults or a stock plunges in price, they are called risky. But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren’t risky when the investment was made? Not at all. The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made.

There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.

Many market participants believe that investment risk is intrinsic to specific securities, as it is to activities like hang gliding and mountain climbing. Using modern financial theory, academics and many market professionals have attempted to quantify this risk with a single statistical measure, beta. Beta. Compares a security’s or portfolio’s historical price fluctuations with those of the market as a whole. High-beta stocks are defined as those that tend to rise by a higher percentage than the average stock in a rising market and decline more than the average stock in a falling market. Due to their greater volatility, high-beta stocks are deemed to be riskier than low-beta stocks.

It's somewhat ridiculous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely form the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments. The price level is also ignored, as if IBM selling at $50 per share would not be a lower-risk investment than the same IBM at $100 per share. Beta fails to allow for the influence that investors themselves can exert on the riskiness of their holdings through such efforts as proxy contests, shareholder resolutions, communications with management, or the ultimate purchase of sufficient stock to gain corporate control and with it direct access to underlying value. Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment’s volatility compared with that of the market as a whole. This too is inconsistent with the world as we know it. The reality is that past security volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.

In addition to the probability of permanent loss attached to an investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value. (Beta fails to distinguish between the two.) Many investors consider price fluctuations to be a significant risk: if the price goes down, the investment is seen as risky regardless of the fundamentals. But are temporary price fluctuations really a risk? Not in the way that permanent value impairments are and then only for certain investors in specific situations.

It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals. The reality may only become apparent after the fact. While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility. Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility.

If you are buying sound value at a discount, do short-term price fluctuations matter? In the long run they do not matter much; value will ultimately be reflected in the price of a security. Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact. For example, short-term price declines actually enhance the returns of long-term investors. There are, however, several eventualities in which near-term price fluctuations do matter to investors. Security holders who need to sell in a hurry are at the mercy of market prices. The trick of successful investors is to sell when they want to, not when they have to. Investors who may need to sell should not own marketable securities other than U.S. Treasury bills.

Near-term security prices also matter to investors in a troubled company. If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company’s stock and bonds. The third reason long-term-oriented investors are interested in short-term price fluctuations is that Mr. Market can create very attractive opportunities to buy and sell. If you hold cash, you are able to take advantage of such opportunities. If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you fo the benefits arising fro the opportunity to buy in at lower levels. This creates an opportunity cost, the necessity to forego future opportunities that arise. If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash. Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others. Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration. Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value. Equity investments in ongoing businesses typically throw off only minimal cash through the payment of dividends. The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase. Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months. An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one’s initial investment returned to cash, one’s profits are as well. Another way to limit opportunity cost is through hedging. A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline. If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities.

The primary goal of value investors is to avoid losing money. Three elements of a value-investment strategy make achievement of that goal possible. A bottom-up approach, searching for low-risk bargains one at a time through fundamental analysis, is the surest way to avoid losing money. An absolute-performance orientation is consistent with loss avoidance; a relative-performance orientation is not. Finally, paying careful attention to risk—the probability and amount of loss due to permanent value impairments—will help investors avoid losing money. So long as generating portfolio cash inflow is not inconsistent with earning acceptable returns, investors can reduce the opportunity cost resulting from interim price declines even as they achieve their long-term investment goals.