IN THE INVESTING WORLD, MOST PEOPLE ASSUME THAT HIGHER RETURNS CAN ONLY BE ACHIEVED WITH HIGHER RISKS – BUT THAT’S NOT ALWAYS TRUE!
“When you’re investing and you want higher returns, you also have to take a higher risks!“
One can hear something like that all too often. Not only by private investors with little experience in the investment market, no, also many professionals are singing from the same song-sheet. This opinion will be exaggerated by those who demonize any investment in the capital market and always believe that investing in stocks is just a losing game.
Undoubtedly, the question of risk is a legitimate and important issue that must be considered. If only because people tend to perceive small losses more than large profits.
For value investors, the risk is a very significant issue as they are less likely to overestimate themselves and are well aware of their financial imperfection.
As the father of value investing Benjamin Graham aptly said:
“The investor’s chief problem – and even his worst enemy – is likely to be himself!”
Being aware of this, the value investor always tries to keep the risk of his investment as low as possible. He has developed a number of mechanisms that have helped him not only to reduce risk, but also to increase long-term return at the same time.
How does he do this?
Minimizing the downside risk while maximizing the upside is a powerful concept. (Monish Pabrai)
The greater the potential for reward in the value portfolio, the less risk there is. (Warren Buffett)
Well, first of all, investing is not a game for him and no bet on higher prices the next day. Value investors don’t invest their money in stocks – but in companies. And a characteristic of a company is to generate value through products and services, which in the end increases the value of the company, and at least the price of its shares.
Value investors focus their investments on things they understand and whose success they are easier able to assess. They concentrate on their circle of competence, where the risk of making a wrong decision is lower than outside.
Value investors don’t follow every trend and every opinion. Rather, they focus on acquiring companies that have an outstanding position in the market – they call it the „moat“. They like companies that have demonstrated their success in the market over the past years, companies with a strong track record. The probability that these companies will continue to do so is much higher than for companies that don’t meet these criteria.
Margin of Safety
The most important thing of risk minimization, however, is the Margin of Safety. It is the central element for every value investor, because the Margin of Safety not only reduces the risk, it also increases the return at the same time. This way, big investors like Warren Buffett achieve an average return of 20% over decades.
How is this possible?
Well, if the value investor has found a company that meets his criteria for an outstanding one, he does not run straight to Mr. Market and buys its stocks. No!
First of all, the value investor is looking for the intrinsic value of the company. This is the basis for his considerations regarding a purchase. As a frugal person, whose first rule is not to lose money, the value investor is not willing to spend too much on the business. His goal is to buy the company at a discount to its intrinsic value. This way, he will get more value than he pays for. Or in other words, he buys a Dollar for 50 Cents.
That’s good for him in two ways. Since the market tends to equalize the price of a stock to the value of a company in the long run, the value investor can assume that the price of the company, ie the stock, will rise in the long run, at least to its intrinsic value. But as the market also tends to exaggerate, it is more than possible that the price of the stock will exceed the value of the company, because sooner or later, Mr. Market will also be aware of the quality of the company. So, the cheaper the value investor bought the stocks, the higher his return.
Many people do it the other way around. They buy at a high level, where returns are small, because an overpriced investment would have to be even more expensive to generate returns. But the higher the stocks, the thinner the air and the more difficult the rise! At the same time, the risk of loss increases enormously. Because at some point – and usually that doesn’t take too long – no one is willing to buy the stock at this too high price. Instead, many repel the expensive stock.
For the value investor, the risk of losing money is low. Since he has bought the company below value, the likelihood that the price of the stock continues to decline is low. That’s why he doesn’t mind if the stock should fall in the short term. He uses these set-backs as a buying opportunity to acquire even more shares of this outstanding company. The value investor knows that in the long run, the price of the company will rise again, at least to the value of the company. And even if this should not be achieved. The probability of a win is high. Because, as I said before, at some point Mr. Market will also realize the quality of the company and he will start to buy its stocks and the price will rise, maybe above the intrinsic value, thus providing the above-average returns of the value investor.
Of course, the value investor may also be unlucky and the company isn’t as outstanding as he thought. Then of course he also loses. But his loss is much lower because of his low purchase price than of those investors who buy at high prices, when everyone buys. And if the company has to be liquidated he may make a good profit, when the book value is higher than the purchase price.
Value Investor Monish Pabrai has pointed out perfectly in his book „The Dhandho Investor“ when he writes: „Heads I win, tails I don’t lose much!“