Buy Businesses, Not Betting Slips

The last chapter of

by Benjamin Graham contains some of the best advice ever given to investors, yet is rarely put into practice by the majority who risk their money on the stock exchanges every day. In the very first paragraph of the book, Graham states that the secret to sound investing is margin of safety. It is a simple concept that virtually no one pays any attention to anymore. The first sentence of the last segment of the chapter perfectly describes what it takes to succeed as an investor.

Graham goes onto add that every security purchase is entering into a business venture, and that each share of stock must be viewed as an ownership interest in a specific business. Long-term investors need not learn to view their portfolio as a collection of companies. Long-term investors would be best served by adopting a private equity-like mindset and time-frame when selecting investments. Stock should be bought because the evaluation for the company shows that the shares are available at a substantial discount to the company's asset value or earnings power, and held until such time as the real value of the company is reflected in the stock price. That is a businesslike approach to investing and has been proven to work time and time again over the last 100 years. Compare that to the way most investors view their portfolios and investment activities. It is more like a casino and they have the unfortunate disadvantage of not being the house. Investors chase stories and rumors around the market like slot players looking for the “lucky machine.” There is an unfortunate emphasis on quarterly comparison of earnings and revenues with little to no thought given to the long term value of the underlying business. Individuals have a terrible “favorites” bias that has destroyed many horse gamblers and like to bet on the stocks that everyone also loves. They buy when they when the market is on a hot streak and leave the game when the tables are running cold.

Investors pay a high price for such behavior. There have been numerous studies from research firms like Dalbar and Cal-Berkley Professor Terrance Odean among others that show that investors and traders vastly underperform the market averages. Trading too much was one of the chief reasons given for underperformance, according to most of the academic research. Dr. Colin Cramer of Caltech was just awarded a MacArthur Genius Grant for a paper he co-authored, "Using Neural Data to Test : A Theory of Investor Behavior: An Application to Realization Utility.” The paper showed that investors were too quick to take small gains rather than allowing profits to accumulate and returns suffered greatly as a result. According to Andrew Lo of MIT, the most important mission of a long-term investor is to survive for the long-term, it is at first glance difficult to understand why investors and traders operate with such a disregard of margin of safety. Viewed with an understanding of psychology, it becomes easy to understand.

People like excitement and owning popular stocks can give them an adrenaline rush similar to placing a bet. We like to be part of the crowd, so we tend to own the same stocks everyone else. We like to take gains, so we take short term gains and search for systems that allow trading the market for instant gains. When we give into these psychological obstacles, business becomes less businesslike and more like gambling. When you run out to buy a stock like

at 391 times trailing earnings and almost 100 times the always highly accurate estimates for next year, you are not investing in the long-term future of a business. You are making a bet in a popularity contest with the hope that someone else will be willing to make the same bet at a higher price. When you buy shares of a stock like

that is losing money and trading at more than 100 times hoped for earnings next year, you are simply making a bet that everyone else will love the story and make the same bet that you are at higher prices. It is a game of “pass the burning match” with real money on the line. It has been proven that investors have too short a time frame and trade entirely too much, yet the behavior continues at the cost of missed returns and lost money. Most would be far better served by taking a more business like approach and buy based on the value of the underlying company and hold for longer periods of time. Investors will fare better with concentration on buying companies instead of betting slips.