My Key Takeaways From Chapter 20 Commentary 20 of the Intelligent Investor. Part 16/16.

Chapter 20 “Margin of Safety” as the Central Concept of Investment

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secret of sound investment into 3 words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy-often explicitly, sometimes in a less direct fashion.

Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.

In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds.

However, the risk of paying too high a price for good-quality stocks-while a real one-is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin.

Theory of Diversification

There is a close logical connection between the concept of a safety margin and the principle of diversification.

*Roulette. The more number he wagers on, the better his chance of gain.

A Criterion of Investment versus Speculation

We say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.

To Sum Up

And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must run in accordance with accepted business principles if it is to have a chance of success.

•   “Know what you are doing-know your business.”
•   “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.”
•   “Do not enter upon an operation-that is, manufacturing or trading in an item-unless a reliable calculation shows that it has a fair chance to yield a reasonable profit.
•   “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it-even though others may hesitate or differ.”

Commentary on Chapter 20

“If we fail to anticipate the unforeseen or expect the unexpected in a universe of infinite possibilities, we may find ourselves at the mercy of anyone or anything that cannot be programmed, categorized, or easily referenced.” – Agent Fox Mulder, The X Files

When he was asked to sum up everything he had learned in his long career about how to get rich, the legendary financier J.K. Klingenstein of Wertheim & Co. answered simply: “Don’t lose.”

You should always remember, in the words of the psychologist Paul Slovic, that “risk is brewed from an equal dose of 2 ingredients-probabilities and consequences.” Before you invest, you must ensure that you have realistically assessed your probability of being right and how you react to the consequences of being wrong. Concludes Bernstein: “In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.”

My Key Takeaways From Chapter 16 Commentary 16 of the Intelligent Investor