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Margin of Safety Investing Strategy

Andrew — Tue, 12 Jan 2010 23:22:14 +0000

Margin of Safety is one of the most popular value investing strategies made popular by stock market legends like Benjamin Graham (father of value investing) and Warren Buffet.

Margin of safety is simply a value stock investing model where the investor assigns a margin of safety to his/her value assessments. In value investing, the investor estimates (or predicts) the intrinsic value of a stock. The concept is that every stock has an intrinsic value and price changes from this intrinsic value is just deviations resulting from the actions of market forces. The stock will often return to its intrinsic value when the market forces weaken.

Thus investors who buy stocks when the trading price is below the intrinsic value and investors who sell stocks when the trading price is above the intrinsic value will profit. But what make value investing difficult is predicting the intrinsic value of stock. There are no established rules for finding out this. Investors should develop their own strategies and models for this purpose, according to availability of information and analysis tools he has.

Many traders use different indicators like book value, open offer, P/E ratio, asset to liability ratio, institutional investments, investments in other companies, etc to finding the intrinsic value of the stock.Margin of safety investing strategy easily overcome this difficulty of predicting the intrinsic value. Investors assign a safety margin as percent of predicted intrinsic value (usually is 30 to 40 percent of intrinsic value).

Margin of safety investors only buy stocks when they are trading below margin of safety. In this way he/she can minimize the risk/error of predicting the intrinsic value. The more the percentage of margin of safety the lower the chance of risk, and the better the chance of profit. For example is the predicted intrinsic value of a stock is $10 and margin of safety is 30%, then the trader only buys the stock if the current trading price is below $7 ($10 – 30% of $10). If the actual intrinsic value is only $9, and the stock returns to this level, the investor will have a profit worth $2. The main advantage of margin of safety investing strategy is that it offers a margin rather than a fixed price to reduce risk.

It favors all type of investors, both experienced and novice investors, and does not necessitates any position sizing or market performance requirements. But the disadvantages are that it does not present any rules for assigning margin of safety and does not consider market factors. Also there is chance of substantial loss when margin of safety is less and scarcity of opportunities when margin of safety is high.

What is Capital Growth Investment Strategy?

Andrew — Tue, 12 Jan 2010 11:11:54 +0000

Capital growth investment strategy is a widely accepted and followed portfolio management strategy. As the name suggest, the strategy aims at capital growth, maximizing portfolio value, over time. Before we start, here is the danger signal – capital growth strategy is a high risk investment strategy which requires great investment discipline and money management. A portfolio which follows capital growth strategy is mainly comprises of equities. Often more than 60 to 70 percent capital is invested in stocks, preferably growth stocks. Remaining portfolio can be constituted of low profit low risk investments such as fixed income securities, money market funds, cash, and/or precious metals like gold to limit overall portfolio risk. The exact portfolio capital allocation depends on many things like individual profit goals, risk tolerance, risk capital involved, portfolio size and investing experience. Many times one can see capital growth portfolios which allocate more than 90 percent capital to equities. Capital growth investors often prefer small and mid cap stocks over large cap stocks, because these show greater growth and are expected to offer increased return over time. Diversification of portfolio is important in capital growth strategy and is achieved by investing in different products like stocks, options, futures, ETFs, funds, bonds, etc. Portfolios which allocate most (all) of the capital to equities achieve diversification by investing in different industry stocks, different markets, using derivatives to hedge risks, and by investing in both high growth high risk stocks and low profit low risk stocks.Capital growth investment strategy is a long-term strategy, which may or may not require periodical reassessments and rearrangements of portfolio allocations. Investable stocks are found using various growth investing tools and strategies. Active portfolio management is recommended for experience investors, to replace low performing investments with high performing ones. But remember, active management often requires greater costs. The advantages of capital growth investment strategy involve faster increase in asset value and better chance of profit than most other investment strategies. The disadvantages include higher risk, unpredictable returns and high volatile portfolio. With capital growth strategy, market entry and exit timings are very important; and there are too many market, risk and economical factors to be considered. The silver lining is ‘irrespective of frequent ups and downs, the equity market shows almost steady growth in long-term; which is higher than most other financial markets’.