Chris Lau - Seeking Alpha

Sunday, September 19, 2010

The Thing about Margin of Safety...

The risk that a security will decline is quantified using a margin of safety. Howard Marks comments on the downside to using a margin of safety in the Sep/Oct edition of CFA Magazine. Marks is Chairman of Oaktree Capital, a firm that manages over $75B in assets. He talks about margin of error (my emphasis in bold):
I’m a worrier. I always ask myself whether I’m being too cautious. I believe strongly that
girding for bad times, and thereby ensuring margin for error, is more essential than preparing for good times. If you prepare for and count on good times, their failure to materialize can knock you out.
There’s a downside to this, however. Having a margin for safety in your portfolio means you can’t always maximize returns. The people who are sure what’s going to
happen and turn out to be right—due to skill or luck— are the ones who’ll maximize. Those who aren’t sure what is going to happen and build in a margin of safety are unlikely to maximize under any single scenario. As investors, we all have to choose whether we’re going to play mostly offense or mostly defense.
As investors, we all have to choose whether we’re going to play mostly offense or mostly defense.

The last several decades were marked by increasingly aggressive behavior, what I call “willingness.” Then there was the trend toward levering up in order to do more than one’s capital permits, or “expansiveness.”  Finally, we all observed the bullishness that produced rising asset prices.
These three trends reached a peak in 2007, and it’s easily summed up in what I find to be the greatest investment adage: “What the wise man does in the beginning, the fool does in the end.” I’m not saying leverage is a mistake, but it’s a mistake when it’s carried too far. There’s nothing in the investment business—no asset class, no single investment, no strategy—that’s a good idea or a bad idea. Everything is a good idea or a bad idea at a particular price and at a particular time. It’s when people forget this that they get into trouble.