The price is not the value – Mr. Market and the margin of safety

Benjamin Graham taught investing at Columbia University, and among his students sat a young Warren Buffett. Buffett has since called The Intelligent Investor the best book on investing ever written. It came out in 1949, and the most widely used editions are the revised one from 1973.

The book is heavy going and full of calculations that are out of date. But three of its ideas have become so central that they are used by people who have never opened it.

Investing or speculating

Graham starts with a definition stricter than the one most people use: an investment presupposes thorough analysis, protection of the principal and a reasonable expected return. Anything that does not meet all three is speculation.

Graham's three requirements

Investing

All three must be met

• Thorough analysis
• Safety of principal
• An adequate expected return

Speculating

Everything else

• Can be perfectly fine
• Provided you know that is what you are doing
• And that the amount can afford to be lost

It is not a moral judgement – Graham thinks speculation can be fine, as long as you know that is what you are doing and have set aside a sum you can afford to lose. The mistake is speculating while believing you are investing.

Mr. Market

The best-known image in the book. Imagine you own a small part of a business together with a partner called Mr. Market. Every day he drops by and gives you a price: he will buy your share, or sell you his. The price swings wildly, because he is extremely moody. Some days he is euphoric, other days despairing.

The point is what you do with it. You are under no obligation to trade. You can say no thanks every single day. And you can use him: buy when he is despairing, sell when he is euphoric. What you should not do is let his mood decide what you believe the business is worth.

Margin of safety

The margin of safety

What you payThe price in the market today

What you think it is worthYour own assessment of the value

Low priceHigh price

Graham’s own answer to what investing boils down to, if he had to pick three words: margin of safety. Pay clearly less than what you believe something is worth.

The gap is not a bonus. It is there because your analysis may be wrong, because the future may disappoint, and because unexpected things happen. The margin is what lets you keep going when you are wrong – and you will be, sometimes.

The same idea is why he warns against paying too much for growth. A good business can be a bad investment if the price already assumes everything goes well.

Defensive or enterprising

Graham divides investors in two. The defensive investor does not want to spend time and effort following the market, and should therefore hold a simple, broadly spread portfolio with fixed, regular purchases. The enterprising investor is willing to put in substantial work, and can look for mispricing – but must then actually do the work.

The key message is that there is no middle level. Half-hearted stock picking gives you the costs of being active without the benefits.

What is dated

The specific numerical tests – particular requirements for debt ratios, dividend history and pricing – were written for a different market and a different era, and cannot be applied mechanically today. The accounting examples are just as old.

It is also worth noting where Graham himself ended up. Late in life he said he no longer recommended the thorough analytical work for most people, because the market had become more efficient. A broad index fund, bought regularly over a long time, would give most people a better result. That is worth keeping in mind when reading a 500-page book on stock analysis.

This is not a recommendation to buy or sell anything.

Main topics

• The line between investing and speculating
• Mr. Market as an image of how the market behaves
• Margin of safety – paying less than something is worth
• Price versus value, and why they are not the same thing
• The defensive and the enterprising investor
• Diversification and fixed, regular purchases
• Why Graham himself ended up recommending index funds for most people

Questions this episode answers

• What is the difference between investing and speculating?
• What is a margin of safety in investing?
• Who is Mr. Market?
• What is the difference between the price and the value of a share?
• Should I pick shares myself or buy index funds?
• What is a defensive investor?
• Why is it dangerous to pay too much for growth?

Key points

• Investing requires thorough analysis and protection of the principal. Everything else is speculation.
• The market gives you a price every day. It is an offer, not a verdict on the value.
• The margin of safety is the gap between what you pay and what you believe something is worth.
• Most people are defensive investors, and should arrange things accordingly.
• Graham himself concluded that index funds suit most people best.

Sources and references

• Benjamin Graham – The Intelligent Investor (1949, revised 1973)