According to Ben Graham, there are two types of investors: predictive and protective. Predictive investors are most concerned with the future. They try to predict it by forecasting units sold, ASP, and margins far beyond the present, in order to get a sense of what the business will be worth many years from now. They get specific in their demand forecasts, making assumptions based on careful study of industry trends or extrapolation of past performance. In Graham’s view, this almost always leads to overvaluation when the indicators are favourable.
The alternative, in his view, is ensuring a margin of safety. This is the approach of the protective investor. A margin of safety simply means believing the market is vastly wrong on the price of a business, rather than merely probably wrong. It is the tool that forces humility into your investing activities. It is an acknowledgment that we cannot predict the future with any real reliability. Things go wrong. Indicators are often wrong. We live in what’s called a “complex adaptive system,” where small changes in one part can produce large changes across the whole. The margin of safety, therefore, gives us room to be wrong. It protects us from ourselves. It ensures that if we are wrong, our losses are minimized, and it has the added benefit of increasing our upside when we’re right.
When The Intelligent Investor was written, Graham was primarily referring to buying businesses below their book value. That is, businesses whose parts could be sold for more than what they were priced at in the market. Nowadays, you won’t find these businesses very often, if at all. Rather, if we want to invest, we have to do a bit of both investing styles: we have to predict the future, hopefully with conservatism, and only on businesses where our sense of the future is above average in terms of clarity, and then also build in a margin of safety to our buy price before taking action.
Connections
Act On The Present, Not Forecasted Futures
Link Explanation: The linked note above discusses the fundamental inability of the investor to predict the future. It recommends basing your actions on the present, not the forecasted future. This is effectively the same message as Graham recommends above. While Graham recommends literally buying assets for less than they are worth, Marks recommends reading the environment you are in and adjusting your actions according — being less active in times of exuberance and more active in times of pessimism. The connective tissue between the two is a sense of humility in the investor and their actions.
Detailed Forecasting Adds Little Value
Link Explanation: The linked note above is also extremely similar and in essence predicated on humility in the investor. Nowadays, it is necessary to do some modelling and forecasting to estimating the intrinsic value of a business. But, the investor must be weary of their own work. Modelling is the embodiment of bias. It takes the intangible feels we have and puts them into numbers, conveying a sense of false specificity and confidence. This is nonsense. Our models are just feelings, so Graham’s margin of safety is the mechanism that protect us from ourselves as investors.