I am continuing here with Warren Buffett’s favorite 2 chapters of any book of all time. If all investors would follow these two simple concepts, trillions of dollars would have been saved in the stock market!! The two concepts explained in these chapters are the framework of Buffett’s investing methodology and are a huge part of his incredibly successful career. The two chapters are 8 and 20 of the revised edition of the Intelligent Investor, by Benjamin Graham. I will begin by explaining chapter 20, which deals with investing only when a large margin of safety.

The importance of behavioral finance and Graham’s concept of Mr. Market are some of the most difficult ideas to master in investing. Benjamin Graham strongly believed in the influence of behavioral finance on people’s long term returns in the stock market. He believed that people often lost rationality when investing because of two influences: greed and fear. In rising markets, people witness the profits that their friends and neighbors are making and become greedy and think everyone can do it. Unfortunately, many of these people buy in near the top of the market, because this is when the gains are the most obvious. Suddenly, the market turns and prices start plummeting to reflect the overvaluation of stocks in the market. However, instead of simply returning to normal levels, fear sets in and stock prices will drop substantially below their intrinsic value. Now, the investor who finally bought in near the top is reminding himself why he never should have invested in stocks, because they are too risky, and fed up with their loss of money they sell near the bottom. His fear of whatever is currently pushing the market down, whether it is a poor outlook for the economy, inflation, or deflation, causes fear which then spurs irrational selling of stocks.

Benjamin Graham noticed how fear and greed dictate people’s decisions in the market, he created a story based on the idea of a man named Mr. Market. He said that “you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.””

To return to our unfortunate investors, those who let Mr. Market guide them end up always losing money, because they only buy when prices are high and sell when prices are low.Eventually these investors become convinced that they cannot make money in stocks, and curse common stock investing, instead of realizing that it was their personal strategies of investment in stocks that did not work, not investing in stocks itself. On the contrary, investing in common stocks has proven the most profitable investment vehicle in history

“Value investing, the strategy of investing in securities trading at

an appreciable discount from underlying value, has a long history

of delivering excellent investment results with very limited

downside risk”

~Seth Klarman

You would think that Warren Buffett’s favorite 2 chapters of any book of all time would be pretty useful? You would be right in thinking so, the two concepts explained in these chapters are the framework of Buffett’s investing methodology and are a huge part of his incredibly successful career. The two chapters are 8 and 20 of the revised edition of the Intelligent Investor, by Benjamin Graham. I will begin by explaining chapter 20, which deals with investing only when a large margin of safety.

My investing philosophy is based primarily on investing in common stocks with a significant discount to their intrinsic value.This concept originated with Benjamin Graham, the father of value investing. It has been followed by some of the most famous investors of all time, including Warren Buffett, Graham’s most famous and successful student, and many others such as Seth Klarman, Bill Ruane, and Charlie Munger. Investing with a margin of safety involves evaluating the intrinsic value of a company, comparing the current market price to the calculated intrinsic value, and only investing when there is a substantial discrepancy.

As an example, imagine I value General Electric’s shares to be worth $30/share, and they are trading for $10/share, I would be investing in each share with a margin of safety of essentially $20/share. The reason for investing with such a substantial margin of safety is because investing is an imperfect art. There is no way to perfectly forecast the future earnings of corporations; there is, however, the ability to approximate earnings and estimate a value for a company. Since we are prone to error, the margin between the current market price and our purchase price provides the safety for our investment. To return to the GE example, if I am off on my estimation of GE’s value by $14/share, and they are actually only worth $16/share, I am still purchasing GE’s shares at $.625 per dollar ($10/$16). Consequently, the larger the margin of safety that exist, the safer the investment opportunity is for the investor.

The corollary to this is that the investment has a greater prospect for a high rate of return because it has farther to return to its intrinsic value. So if GE shares are priced at $10/share and the intrinsic value is $30/share, it will have to increase 200% to return to its intrinsic value. If the intrinsic value is only $20/share, it only has to increase 100% to reflect its intrinsic value. Therefore, the larger the margin of safety that exists, the greater safety of principle there is and the higher expected rate of return. This belief is contrary to most investing philosophies that assume one must take on higher risks to achieve greater rates of return. We believe exactly the opposite, that the less risk, the higher the expected rate of return.

This is what makes investing with a large margin of safety such an effective investing methodology. In 1984, Buffett spoke of the now famous “Superinvestors of Graham and Doddsville” , where he described a group of nine investors who all invested using the principle of a margin of safety, and who all beat the market with low risk over a long period of time. For more information, visit this linkhttp://en.wikipedia.org/wiki/The_Superinvestors_of_Graham-and-Doddsville. In this article, Buffett provided convincing evidence as to the safety and high rates of return possible through the use of this style of investing.

Another important concept is that investing with a margin of safety also inadvertently allows investors to sell in markets that are too expensive and therefore risky, and buy in markets that are cheap and therefore low risk. This occurs because as the investor searches for companies, he will only find companies at a steep discount to their intrinsic value in down markets, and in inflated markets will not find any acceptable investment opportunities, and will sell his holdings when they are selling substantially above their intrinsic value. So again using GE as the example, in 2007 when GE was trading for $40/share, we would have sold all of our holdings, since we valued GE at $30/share, but once GE fell substantially below $30/share, we would have started buying again. So in this case our investment methodology would guide us to stay away from the market when common stocks are too expensive, and buy aggressively when they are cheap.