1 Shocking Reason Why You Should Heed this Investing Concept

Danger sign

Avid Foolish readers may remember that two of Warren Buffett’s favorite investing concepts came from a book written almost 65 years ago. That book is Ben Graham’s “The Intelligent Investor”. As for Buffett’s favorite investing concepts, we have shared in the past that one of it was the margin of safety.

But there is more to this pragmatic concept.

My American colleague Morgan Housel recently penned an article about understanding the idiosyncrasy of risks. Within his article, he shared interesting quotes from the author of “Risk Savvy”, Gerd Gigerenzer. One of the quotes is actually a telling paragraph which explains why regular people should treat the investing concept of margin of safety as a must have:

“People aren’t stupid. The problem is that our educational system [referring to the USA] has an amazing blind spot concerning risk literacy. We teach our children the mathematics of certainty — geometry and trigonometry — but not the mathematics of uncertainty, statistical thinking. And we teach our children biology but not the psychology that shapes their fears and desires.”

In short, Morgan argues that shockingly, people often fear risks which are rare, and instead, underestimate risks which are more common.

When this revelation is applied to the idea of margin of safety, it brings new light to its importance in investing. Said another way, margin of safety should not just be applied because it is a conservative approach, and something which is “good to have”. As it turns out, the investing concept is closer to a “must have” due to the tendency of people to underestimate certain risks. Unfortunately, that would include people like you and me.

The good news is that risks, even the ones which are unknown, can be managed through a variety of ways. Perhaps, the crucial first step is to acknowledge that some risks cannot be known. From then on, a reasonable discount for the unknown unknowns can be better applied.

In Singapore’s share market, a company like Hongkong Land Holdings Limited (SGX: H78) is currently trading at a price-to-book ratio of 0.6. When we look behind the curtain at the company’s business, we will find 13 properties located in the prime Central Business District of Hong Kong. Some of these properties include One Exchange Square, Jardine House, Gloucester Tower, and Alexandra House. You can find out more about the location of the 13 properties in the company’s analyst presentation slide-deck here.

Closer to home, Hongkong Land also owns One Raffles Link, and a 33% ownership stake each for One Raffles Quay and Marina Bay Financial Centre. The properties in Singapore and Hong Kong make up 80% of the properties owned by the company (by square feet of nett floor area). On the surface, it would appear that the properties represent good value given their prime locations. So using what we learned, the current 40% discount from book value for Hongkong Land’s shares might just be the kind of margin of safety which can help cater for things unknown.

Other approaches to manage risks include smaller allocations and diversification over time and across your portfolio. For diversification, the investor might consider an index tracker like the SPDR STI ETF (SGX: ES3). The exchange-traded fund (ETF) consists of the 30 SGX-listed companies which represent the Straits Times Index.

Foolish Bottom Line

While we all would like to have certainty of returns for our efforts in investing, the truth is that investing is closer to a game of probabilities than one of rigid certainties. Despite the uncertain pay-offs at times, it’s important to note that the maximum a share can lose is 100% but the long term gain of a share can go past 100% and beyond. When we consider the mathematics of that, we can take comfort from the fact that we, indeed, do not have to be right all the time in order to generate a reasonable long term return – we just have to be right more often than we are wrong.

This revelation will come with an added bonus, for I am certain that wives and girlfriends around the world will welcome the fact that we (meaning men) are not right all the time.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.