The unreasonable man adapts conditions to himself…. All progress depends on the unreasonable man.
—GEORGE BERNARD SHAW
My one regret in life is that I am not someone else.
—WOODY ALLEN
THE WISDOM OF WARREN BUFFETT and Jack Bogle, two icons of modern investing, points in completely opposite directions, yet still converges. Buffett personifies an utterly idiosyncratic style of active investing, while Bogle created the Vanguard S&P 500 index fund. Obviously, your portfolio can’t look exactly like the market and most dissimilar at the same time. But both approaches are systems for minimizing regrets of the sort discussed in this book. The genius of index investing is that being average avoids (by spreading thin) deep regrets brought on by the extremes of emotions, ignorance, fiduciary malfeasance, obsolescence, overleverage, and overvaluation. And anyone can index! Indexers have no regrets over missed opportunities, because the index holds a smattering of everything. Buffett’s method is much more demanding, as his goal is to avoid regret altogether. He will not buy a security until he sees ample margins of safety considered from multiple vantage points.
Buffett and Bogle do not represent the only conceivable ways to invest safely and some may prefer more speculative approaches. The path you choose—and sometimes must develop—depends on your emotional character, knowledge, and curiosity. It is always excruciating to rationally examine one’s own motives, capabilities, and limitations. But it’s important to do it. Many people prefer the contentment of the easily practical to shooting for (and often missing) the stars. Don’t torture yourself if you’re just not cut out to bend it like Buffett!
Long ago, Buffett said that an investment lifetime scorecard should include just twenty punches. My funds have never, ever held so few stocks. Even when I see nothing on offer that Buffett would completely approve of, my mandate is to act. I don’t see the world in black and white, only in shades of gray. Plus, I’m curious and interested in learning, and so I often test the boundaries of my circle of competence. I try to see things from others’ perspective and uncover the good in people before I judge them. In the process, I’ve met a few bad guys. Permanence and resilience intrigue me, but experimentation and adaptability fascinate me. While I’m more patient than many, I’m not immune to the exhilaration of a sudden windfall. Still, I do want to invest safely.
I won’t buy an asset unless it is:
1. Safe from rash decisions
2. Safe from misunderstanding of facts
3. Safe from foreseeable fiduciary misuse
4. Safe from obsolescence, commoditization, and overleverage
5. Safe when the future doesn’t turn out as imagined
1. Loopy Mr. Market
Bogle and Buffett try to keep their investment decision-making safely apart from their emotions, aiming for fewer, more rational judgments. They cultivate the art of observing mindfully and dispassionately. They don’t want emotions to lead to rash actions. To be sure pain won’t guide their actions, some Bogle devotees (“Bogleheads”) invest preset amounts every month, no matter how the market is behaving. They will buy at market peaks, but also in valleys, believing it should all come out in the wash. Index funds are broad based and bland, and not tasty fodder for hot tips and fantasies that individual stocks can inspire. By analogy, I’d suggest that diets of powdery shakes or celery or tofu might work not only because they contain fewer calories, but also because they make eating less tempting. That said, there are still swarms of day traders in index exchange-traded funds whom Bogle rightly scolds. Minimizing turnover averts bad decisions, commissions, and fees and defers capital gains taxes.
One recipe for happiness is selective inattention and lethargy. The pain of a dollar lost is greater than the joy of a dollar gained, so the more you watch prices bounce around, the glummer you’ll be. Spend more time gathering information that bears on your investment’s value, rather than tracking the price. If news won’t matter in a year, skip it. Sometimes you will miss a real turning point. My permanent resolution is to read more books, annual reports, and publications like the Economist and to reduce emails and social media. It’s said that a good marriage begins with eyes wide open but continues with almost willful blindness to small flaws; the same applies to stocks. Why rush decisions? You might know more tomorrow.
Buffett not only restrains himself from knee-jerk emotional reactions, waiting until the facts are compelling, but he also profits by buying when others find it uncomfortable, even agonizing. Usually, the most abrupt price reactions come when the moody Mr. Market correctly senses an existential threat. Buffett bought into the Washington Post in 1973 after it exposed the story of the Watergate break-in. Allegedly, President Nixon wanted to shut down the newspaper and rescind the company’s Florida broadcast licenses. That’s not supposed to occur in a functioning democracy, but if everything had been by the book, the Watergate scandal would never have happened. In the meantime, with an ongoing recession, a few advertisers pulled back. It wouldn’t have been irrational to have concluded that earnings would be impaired in the near term and that the risk that the Post would be shuttered was material. Only with hindsight can we say that these fears were overblown. In fact the Post’s stature was actually improved, and its reporters Woodward and Bernstein became folk heroes.
None of Buffett’s major investments have had a more terrifying backdrop than his purchase of GEICO shares in the mid-1970s. Unlike Buffett’s other coups, GEICO was bleeding profusely, and some thought it was a goner. The losses stemmed from GEICO’s expansion outside its original circle of competence—auto insurance for low-risk government employees. Massive underwriting losses meant that GEICO had to dump securities into a slumping market to raise cash to pay claims. The insurance commissioner was poised to declare GEICO insolvent. The CEO was sacked. GEICO’s husband-and-wife founders had passed away. Later their son died, apparently by committing suicide. What part of this doesn’t scream, “RUN!” to you? But, as with successful cancer surgery, it turns out this patient was mostly healthy, and the noxious parts could be isolated and removed. Still, no one breathed easy for many years.
2. Invest in What You Know
Defining a circle of competence can help keep your investments safe from misunderstanding. Stick with companies where you can identify the key factors that will determine their income out some years, and how those factors interact. For an index investor, these factors are more macroeconomic than they are for individual stocks. Usually, analysts start with an opinion about whether corporate profit margins are cyclically above trend or below, and whether mean reversion will help or hurt. They then factor in a growth rate, often stated as real gross domestic product growth plus inflation. This growth estimate tends to be overstated; it doesn’t account for dilution from stock options or the GDP growth coming from start-up and small businesses that weren’t in the index. (Think about Google, Facebook, and Uber.) Finally, a reasonable discount rate is needed. If you’ve read this far, you are probably financially literate enough to include the S&P 500 index in your circle of competence.
Because investors in S&P 500 index funds hold all industries, they don’t involve themselves in top-down sector rotation. But as owners of the market, they find that the top-down economic approach opens the door to market-timing. My prejudice is that basically no one is competent to rotate between sectors or time markets, especially on a high-frequency basis. Even the slow-motion timing known as asset allocation is tricky to get right, and few have the requisite patience to stick with it. Economic processes are too complex and have too many hidden links, often involving human behavior that can change, for mechanical systems to work reliably. By disparaging sector rotation and market-timing, Buffett and Bogle are trying to keep you inside your circle of competence.
The S&P 500 index also doesn’t have heavy concentrations of foreign-headquartered businesses or mysterious derivatives, which may be outside your circle of competence, but other index funds do. Arguably, you don’t need foreign index funds for further diversification because the companies in the S&P 500 have extensive operations overseas. If you do venture abroad, you should consider whether the country has rule of law and political stability sufficient to make forecasts of the intermediate future credible. Consider how financial information will be translated, especially if a country’s culture, institutions, and language are unlike yours.
Unlike the S&P index, Berkshire Hathaway is not represented in every industry and apparently considers many to be beyond its circle of competence. Based on his record, Buffett has immense skill in branded consumer products and services, and also insurance and finance. Pharmaceuticals might be in, but not medical devices or services. Other than IBM, technology is absent, almost as if PCs, smartphones, and the Internet never existed! Basic materials and mining are almost completely neglected, as are agricultural commodities. But even in industries that it generally avoids—like automakers—Berkshire finds segments where it does play, like auto dealers. Railroads are in, but not trucking and shipping.
Buffett disclaims any ability to forecast economic data, and does not use economic forecasts to make investment decisions. On average, the businesses under the Berkshire umbrella are not particularly cyclical, so he doesn’t need an economic prediction. The economic bet that Buffett does like to make is that over time America will grow, bringing with it, among other things, increased freight volumes on the Burlington railroad, which will spread its fixed costs and boost profits.
Even though Berkshire Hathaway has dealt in complex financial derivatives, Buffett doesn’t seem overeager to include them in his circle of competence. He has called them “weapons of financial mass destruction,” and spent years winding down a derivative portfolio acquired with reinsurance giant Gen Re. With famously brilliant staff like Ajit Jain, I would think that if any company were competent to trade in derivatives, it would be Berkshire, and only gingerly.
Occasionally, Berkshire has dabbled in shares overseas, mostly in Europe, with investments in Guinness, Glaxo, Tesco, and Sanofi. Again, they were mostly noncyclical, not overly complex businesses with powerful brands, patents, or competitive positions. They are in industries that have been around for decades and seem unlikely to become obsolete. They are in countries with rule of law. Perhaps it’s my own leaning, but Buffett seems to fancy English-speaking countries. My take is that he sees vast swathes of the developing world as outside his circle of competence, including Latin America, Africa, and Western Asia.
Both GEICO and the Washington Post Co. were relatively simple, understandable, stable, resilient businesses. Auto insurance is more of a “what-you-see-is-what-you-get” line than many categories of insurance. Insurance premiums are collected before claims are paid, so with proper underwriting, cash flow is almost always positive. Because of its direct sales model, GEICO has lower overhead costs than insurers that use agents. GEICO’S policy limits are small, and while the odd claim may take years, most are settled in months. After an accident, premiums are hiked. Historically, GEICO focused on safe drivers, which gave it below average claims losses. In return, GEICO charged moderate premiums. Most policyholders stayed enrolled, so GEICO had a good fix on its future premium income. It didn’t take a management guru to spot what GEICO needed to do to turn around. It needed to get rid of unprofitable policyholders or raise premiums.
In the 1970s, subscription revenues for newspapers like the Washington Post were quite predictable, but ad sales bounced around cyclically. Washington, DC had a growing population of government workers, so the trend for circulation and ads was up, quite steadily. As the town’s leading newspaper, the Washington Post reached the broadest audience, which attracted advertisers from other papers. It could also afford to spend more on a superior newsroom, or spread the costs over more readers and earn a better profit margin—or both. The costs of newsprint and ink were somewhat variable, but the Post acquired an interest in a paper mill. Warren Buffett didn’t need to build a three-thousand-line spreadsheet to figure out what was happening at the Washington Post or GEICO. They were absolutely within his circle of competence.
3. Honest, Capable Intermediaries of Trust
For better or worse, none of us can control the disposition of our capital from start to finish; at some point, we all depend on agents we trust. To reduce it to the absurd, dispensing entirely with agents would mean you would have to do the work of every employee of the firms you invest in. Obviously, some agents matter more than others. The most heartbreaking situation is to be betrayed by someone you trusted completely. Among other things, the purpose of finance is to connect agents with other agents, and ultimately owners, in a web of trust. When trust is deserved and reciprocated, everything works perfectly. But how does this work for those of us who just want to collect our gains without too much fuss? Everyone may act in his or her own self-interest, but not everyone defines self-interest in the same way.
Owners of index funds are safe from total misappropriation, but instead receive an actuarial slice of trouble. If two CEOs are crooks and twenty are idiots out of five hundred, index owners suffer in line with the averages. Except where the system is deeply corrupt or dysfunctional, these damages get lost in the mix. Management fees on most index funds are around 0.1 percent of assets, a relatively tiny bite out of returns. But even passive investors need to watch to ensure that it is their interests that fiduciaries are safeguarding. Appropriately, I think, some sponsors of index funds have increasingly taken these concerns to heart in recent years, voting shares in ways intended to improve corporate governance. When Japanese companies pile up cash, which earns them nothing, and neither reinvest it nor pay it out as dividends, managers are serving interests other than their companies’ owners.
On the whole, I think the S&P 500 companies are held to imposing standards. They are among the largest enterprises in America, and presumably wouldn’t have reached their dominant position without being well managed, at least historically. Niche companies often have more distinctive product offerings and culture than S&P firms, and are more adaptable. In capital allocation, though, the advantage usually goes to the giants. Being in the spotlight can produce pressures to fiddle the numbers, as with Enron or Valeant, but when combined with requirements for transparency, more often acts as a disinfectant that discourages bad behavior.
Berkshire wholly acquires well-positioned, well-managed companies, and encourages them to stay that way. The main criticism of Buffett’s management style is that he trusts too much. Divisions have their accounts audited thoroughly, and excess cash is swept to Omaha for large-scale capital allocation, but otherwise Berkshire has a very light touch. A headquarters staff of twenty oversees operations employing hundreds of thousands. Instead of seeking detailed budgets and targets, Berkshire instructs its managers to “widen the moat, build enduring competitive advantage, delight your customers and relentlessly fight costs.” Buffett’s ABC enemies are arrogance, bureaucracy, and complacency. The intent is to avoid the pressures and temptations that lead to poor capital allocation or fraud. My takeaway: Don’t invest unless the right incentives are in place. It’s a good sign when management owns a lot of stock.
Berkshire passes both tests of good management with flying colors—offering something distinctive to customers and allocating capital well. The first is accomplished at separate business units, while capital allocation is highly centralized. Many of Buffett’s investments have been nearly synonymous with their category: American Express and high-end credit cards, Gillette and shaving, Disney and family entertainment, Coca-Cola and soda, for example. The wholly owned businesses are also distinctive, but usually in a narrower context. These include Benjamin Moore, Dairy Queen, Duracell, Fruit of the Loom, Flight Safety, and See’s Candies. As long as the businesses continue to delight customers, they will throw off more cash than they need for growth. Incidentally, the focus on delighting customers might screen out bad guys, because businesses that abuse their customers will do the same with others, including owners.
4. Avoid Competition and Obsolescence
No one sets out to participate in something that’s obsolete, drearily commoditized, and wallowing in debt, but that’s how many investing stories end. The S&P 500 will always contain some stocks that are slip-sliding away, but also some of whatever is sparkly and new. I would think that because most S&P 500 companies have been time tested for at least a few decades, they have above average chances of surviving a few more decades. Around 1960, a stock’s average life span as a member of the S&P index was about sixty years; recently, it’s been closer to sixteen years. Shorter corporate life spans aren’t all bad for investors. They mostly reflect increased mergers and acquisitions. Because the S&P 500 is market cap weighted, it is constantly rebalancing toward stocks that have come up and away from those that have come down. Here again, being average protects you from the ravages at the extremes.
The importance of rebalancing and capital allocation can be illustrated with a hypothetical investment in General Motors at $43 a share in 1958; it might have earned a 9 percent rate of return, or been a total loss. General Motors went bankrupt in 2009, and the shares were canceled. An investor who had reinvested all of his dividends and proceeds from spin-offs in General Motors stock would have lost everything. Over half a century, GM had distributed more than $190 per share in dividends and spin-offs, including Delphi and Hughes, worth another $36 if sold immediately. As long as you spent the income or reinvested in something better, the rate of return was satisfactory. This isn’t exactly what S&P index funds do, but they do reinvest income across the portfolio of five hundred stocks.
When Buffett bought into Berkshire Hathaway, it was a doomed textile mill with outdated facilities, selling an insufficiently differentiated product. Without this fiasco, Buffett might have remained blind to the safety provided by moats and unique capabilities. Berkshire was the largest producer of linings for suits, but linings weren’t a branded feature that suit buyers sought out. With rising import competition, Berkshire was no longer the low-cost producer and couldn’t get a needed price increase. Knowing that closing the mills would destroy the local communities, but also that offshore producers would inevitably prevail, Berkshire did not reinvest in the mills, but kept them open for many years despite losses.
As the United States adopted a permanent policy of tolerating massive trade deficits, anything that lacked a strong brand and could be made more cheaply offshore was doomed. While suit linings and Dexter’s line of shoes did not become obsolete, making them in America did. Berkshire had better luck with branded textiles, including Fruit of the Loom underwear and Garanimals children’s wear. Insofar as Berkshire has invested in commodity businesses with products that can be traded internationally, it has favored low-cost producers in lower-wage nations. For example, POSCO, the South Korean steel producer, meets the rigorous quality standards of Japanese automakers, yet it incurs lower costs than Japanese mills.
To guard against obsolescence and commoditization, Berkshire tacked toward recurrently purchased branded services and products that are not changing rapidly and don’t face import competition. For consumer brands like Disney, Gillette, and Coca-Cola, international markets were a wonderful opportunity, not a threat. The other thing Buffett looks for is a barrier to entry, or moat. Initially, I was baffled by Berkshire’s acquisitions in commodity-like services such as railroads and electric utilities, but for a host of reasons these industries are unlikely to see new entrants disrupt the market. Demand is steady and recurrent. Until something like self-driving trucks or renewable energy arrives and becomes commercially profitable, obsolescence will have to wait. By then, rails and utilities may have adjusted to the new world.
Most technology businesses do not fit Buffett’s pattern of evolutionary change, differentiated products, loyal habitual customers, and few competitors. The few that have the last three—including Alphabet, Apple, Amazon, Facebook, and Netflix—are spectacular winners. If change is constant, reinvention must also be. At some point, companies that have conquered the world fall prey to Buffett’s ABC’s of failure: arrogance, bureaucracy, and complacency. Monetizing customers starts to matter more than delighting them. In short, technology is tough. So far, Buffett’s only—and not notably successful—technology stock has been IBM.
The Washington Post remains one of the national newspapers of record, but Buffett did not foresee that the role of newspapers would be diminished by the Internet, which didn’t then exist. In fact, the newspaper was sold in 2013 to Jeff Bezos, the Amazon founder, for $250 million, no more than it was worth four decades earlier. Buffett had correctly identified a durable and growing franchise that threw off cash, which was used to buy broadcast and cable TV properties, addressing the then visible competitive threat to newspapers. Later, Washington Post expanded into educational services by buying Stanley Kaplan. Much later, it acquired Slate, the Internet magazine. By the time the Post was sold, the proceeds were less than one-tenth of the holding company’s assets. While no one could have predicted the Internet, Washington Post survived and prospered by adapting well. Because I’m a mediocre fortune-teller, I look for executives with a learning mind-set.
The Internet was an unexpected boon to GEICO, because it made marketing, rate quotes, and customer service easier and cheaper, reinforcing its cost advantage. It’s yet another case of “buy the users of technology, not the technology stock.” GEICO has kept gaining on the competition and is now tied for number two in auto insurance. Otherwise, the features of car insurance haven’t changed a lot. Until autonomous driving is absolutely foolproof, car insurance isn’t going away. With GEICO, Buffett found a business that has resisted obsolescence and commoditization for four decades and even benefited from change. As a part of Berkshire, GEICO has strong financial backing that will allow it to adapt as needed. It’s worth noting that if Buffett had not recapitalized GEICO in the mid-1970s, GEICO might not have had the flexibility to take advantage of opportunities as they arose.
Many see Berkshire’s low-debt posture as inefficiently conservative, but it prevents being backed into decisions and creates an option to take advantage of unforeseen opportunities. The paradox of cyclical businesses is that at the moments of greatest opportunity, no one has ready money. During the global financial crisis, few others had both the stomach and the cash to buy high-yielding preferred shares with equity kickers. Fast-forward a few years. The 10 percent coupon paid by Goldman Sachs was not available anywhere in good-quality fixed-income securities, and the attached warrants were worth billions. My conclusion: In any industry that is changing fast, or where opportunities come and go, I prefer little debt.
5. Never Ever Pay Full Price
How you think about a safe price for investments depends on how completely you believe in the efficient market hypothesis (EMH). According to true believers, stock prices are always fair, and therefore safe, or at least as safe as equities can be. Manias and bubbles don’t exist, or in weaker form, no one can make money from them. Following this logic, investors should instead focus on setting appropriate expectations for returns. The EMH provided the theoretical foundation for developing the S&P index fund. Bogle extended the EMH by proposing the costs matter hypothesis: Investors should expect to earn the market average return, less expenses and taxes.
One implication is that owners of individual securities should expect the same market return, but with far more variability than with the index fund. Bogle would say, given the same returns and lower risk, go for the index fund! Because there is a (low) management fee on the index fund, owners of specific securities could have lower costs if they rarely traded. But for active fund managers like me, it’s a shot across the bow. Active funds charge higher management fees, and some have high turnover. (In a recent year, my fund had lower turnover than my benchmark, the Russell 2000 index.) When all of the actively managed funds are equally weighted, most surveys find underperformance in line with what Bogle would predict. However, you do noticeably better with funds with low expenses, run by experienced managers, at larger fund groups.
As I see it, on average over time, for an average stock, its price will roughly match its fair value—but what about those extreme outliers? Call it the “sloppy” version of the EMH. The EMH is a cautionary tale warning that securities analysis is hard work, and you shouldn’t blithely assume that you know more than the market. As in every human activity, there’s a spectrum of ability and application. The average player is average, but at the extremes, some are virtuosos, others ham fisted. Likewise, at the extremes, there are bubble stocks and bubble stock markets and incredible giveaways. Most of the time, things are more or less average, so the Bogleheads will be OK most of the time.
What I worry about is when the market is NOT normal but raving bonkers. The day-to-day collective hallucinations involve a short list of darlings rather than the entire market, but bubbles do appear and can be identified. They do pop—timing unknown. And yes, unless you are ultimately vindicated, a persistent difference of opinion with the world is commonly tagged insanity. If you were thinking about prospective stock returns in 2000, when Treasury yields were over 6 percent, the 3.2 percent earnings yield and 2.3 percent Shiller earnings yield should have howled out a warning. Likewise, at its giddy heights in 1989, the Nikkei had an earnings yield of 1.3 percent, while Japanese government bonds yielded 4.5 percent. And then there are tragic cases like Austria, where human events were more senseless than the markets. In these contexts, indexers are safe only in the sense that there is no shame in misjudgment when it is shared with a crowd.
Buffett has made his fortune off of others’ daft behavior, and has said that he is grateful to professors who teach that it is pointless to search for bargains. In particular, he looks for an overreaction to a major problem that can be fixed in an otherwise fantastic business. Such an investment would combine all four elements of value: a high earnings yield, growth prospects, a moat or competitive advantage that protects against failure, and certainty about the future. Except for discontinued activities as in the GEICO case, Buffett’s companies are marked by transparent accounting, with few adjustments, and owner earnings that mirror reported numbers. Situations like that don’t come around often.
A robot could execute Buffett’s first step of buying stocks at low price/earnings ratios (P/Es) on normalized earnings. Washington Post was at eight times earnings when Buffett bought it. Berkshire acquired some GEICO shares at a price that worked out to one and a half times previous peak earnings, and most through a preferred stock that yielded 7.4 percent, which was convertible at the equivalent of 2.5 times previous peak earnings. Wells Fargo came at book value, and less than five times earnings. American Express had a P/E of ten in 1965. Coca-Cola was the glamour stock, at fifteen times earnings. If historical earnings were any guide, the purchase prices afforded margins of safety.
The magical, ineffable part is that in every case, earnings swiftly blew through previous records and made Berkshire’s purchase prices look like astounding anomalies. By the early 1980s, GEICO’s earnings per share were higher than purchase price for the first batches of stock. Five years later, Washington Post earnings were half its purchase price. Over four years, American Express’s earnings soared from $3.33 to $12.00 per share. Coca-Cola’s earnings quadrupled over the next decade. And so on. In every case, the problems really were temporary, and the companies were offering something uniquely valuable to an expanding customer base. Apart from their one-time issues, these were fairly predictable businesses. Putting it all together, their value was much greater than earnings yield alone would indicate. They deserved premium multiples.
For Washington Post, there might have been a 75 percent margin of safety in Buffett’s purchase price. There was an active private market for media properties, and appraisals of Washington Post clustered in the $400 million to $450 million range. The company’s market capitalization was around $110 million, and touched as low as $75 million. I can only reconcile this with efficient markets by assuming that the odds were three out of four that the Washington Post would fold and that its other assets were worthless.
Margins of Safety Reinforce Each Other
A margin of safety in one dimension often supports margins of safety in other dimensions. For example, if you are mindful of thinking rationally, it is easier to see and accept your own limits to circle of competence. If you train yourself to know your limits and admit mistakes, you will also be more able to spot the limited abilities and ethical mistakes of others. If you seek out skilled managers, they may have anticipated the threats of obsolescence, commoditization, and over-indebtedness, and will adapt more successfully. If you have sidestepped the common blind alleys that investors go down when trying to see the future, your estimates of value are more apt to be reliable.
Nothing Is Absolute
Life and investing are inherently unsafe, so all of the margins of safety we’ve discussed are relative, contextual, and involve trade-offs. Consider rationality. Some refuse to invest in sin stocks like tobacco, alcohol, and gambling, and this doesn’t seem irrational to me. They are putting their personal values ahead of any profit they might make on these activities. When Buffett bought a basket of a couple dozen South Korean stocks after minimal research, was that irrational? Or was it rational to conclude that he wouldn’t improve outcomes enough to justify deeper research on a group of stocks with good track records in industries he knew were trading at single-digit P/Es? All of us have moments when we are the moody Mr. Market—hopefully, not too many.
Often there is a trade-off between different types of safety, as with Yukos, where a massive discount to calculated asset value implied that property rights in Russia were anything but secure. Conversely, glamour stocks with superstar CEOs and unstoppable growth are typically priced with a margin of unsafety. The margins of safety that you should not compromise on are the ones you control: your rationality and your circle of competence. If, like me, you are a bit lax on your circle of competence, lifetime learning is the best defense. While you are still gathering facts, small bets and diversification help. (Yes, you also get these through an index fund.) Before investing, you should locate the weakest link in your margin of safety and consider whether it alone could make or break your results.
Whether your path more closely resembles Bogle’s or Buffett’s, you will reduce your regrets by seeking a margin of safety in five steps. (1) Be clear about your motives, and don’t allow emotions to guide your financial decisions. (2) Recognize that some things can’t be understood and that you don’t understand others. Focus on those that you understand best. (3) Invest with people who are honest and trustworthy, and who are doing something unique and valuable. (4) Favor businesses that will not be destroyed by changing times, commoditization, or excessive debt. (5) Above all, always look for investments that are worth a great deal more than you are paying for them.