Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor by Seth A. Klarman

WHERE MOST INVESTORS
 STUMBLE

1.  Speculators and Unsuccessful
 Investors
 Investing Versus Speculation
 Mark Twain said that there are two times in a man’s life
 when he should not speculate: when he can’t afford it and
 when he can. Because this is so, understanding the difference
 between investment and speculation is the rst step in
 achieving investment success.
 To investors stocks represent fractional ownership of
 underlying businesses and bonds are loans to those
 businesses. Investors make buy and sell decisions on the
 basis of the current prices of securities compared with the
 perceived values of those securities. They transact when they
 think they know something that others don’t know, don’t care
 about, or prefer to ignore. They buy securities that appear to
 offer attractive return for the risk incurred and sell when the
 return no longer justi es the risk.
 Investors believe that over the long run security prices tend
 to re ect fundamental developments involving the underlying
 businesses. Investors in a stock thus expect to pro t in at
 least one of three possible ways: from free cash ow
 generated by the underlying business, which eventually will
 be re ected in a higher share price or distributed as
 dividends; from an increase in the multiple that investors are
 willing to pay for the underlying business as re ected in a
 higher share price; or by a narrowing of the gap between
 share price and underlying business value.
 Speculators, by contrast, buy and sell securities based on
 whether they believe those securities will next rise or fall in
 price. Their judgment regarding future price movements is
 based, not on fundamentals, but on a prediction of the
 behavior of others. They regard securities as pieces of paper

to be swapped back and forth and are generally ignorant of or
 indifferent to investment fundamentals. They buy securities
 because they “act” well and sell when they don’t. Indeed,
 even if it were certain that the world would end tomorrow, it
 is likely that some speculators would continue to trade
 securities based on what they thought the market would do
 today.
 Speculators are obsessed with predicting – guessing – the
 direction of stock prices. Every morning on cable television,
 every afternoon on the stock market report, every weekend in
 Barron’s, every week in dozens of market newsletters, and
 whenever businesspeople get together, there is rampant
 conjecture on where the market is heading. Many speculators
 attempt to predict the market direction by using technical
 analysis – past stock price uctuations – as a guide. Technical
 analysis is based on the presumption that past share price
 meanderings, rather than underlying business value, hold the
 key to future stock prices. In reality, no one knows what the
 market will do; trying to predict it is a waste of time, and
 investing based upon that prediction is a speculative
 undertaking.
 Market participants do not wear badges that identify them
 as investors or speculators. It is sometimes dif cult to tell the
 two apart without studying their behavior at length.
 Examining what they own is not a giveaway, for any security
 can be owned by investors, speculators, or both. Indeed, many
 “investment professionals” actually perform as speculators
 much of the time because of the way they de ne their
 mission, pursuing short-term trading pro ts from predictions
 of market uctuations rather than long-term investment
 pro ts based on business fundamentals. As we shall see,
 investors have a reasonable chance of achieving long-term
 investment success; speculators, by contrast, are likely to lose
 money over time.

Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor by Seth A. Klarman