The book "The intelligent investor" is the bible for investing. Warren Buffett proudly acclaims most of his knowledge to this book at an early age of 19. The Intelligent Investor is based on value investing, an approach Benjamin Graham practise while teaching at Columbia Business School in 1928.
The book describes the Share Market as Mr. Market, a moody person who turns up every day at the shareholder's office offering to buy shares or sell his shares at market price. The price put forward by Mr. Market often seems plausible, but at times it is amusing. The investor is free to either agree with the price and trade with Mr. Market, or ignore completely. Mr. Market doesn't mind this, and will be back the following day with another price.
Reason behind this anecdote is that the investor should not make decisions based on the mood swings of Mr. Market as a determining factor in the value of the shares the investor owns.The investor should profit from market folly rather than be a mere participant.Warren Buffet advises to concentrate on the real life performance of the companies and receiving dividends, not to be concerned with Mr. Market's behaviour.
Margin of Safety
Let us look at an example from real world. An engineer needs to construct a bridge which can sustain the weight of 8000 kg. So should the engineer construct the bridge which can support 8000 kg? Or construct a bridge which can support 10000 kg? You are right if the answer in 10000 kg. But why do you need to construct for 10000 kg? Answer is the margin of safety concept. It’s a basic practice that the engineers construct the bridge with a margin of safety.
Just to make sure you are safe while investing,invest in securities which gives you a good percentage of margin of safety. Margin of safety can be decided based on the individual's need and the required margin.
Speculation vs Investing
Another example would be better to explain the concept. You want to buy a property say for example a farmhouse or a restaurant. So when you speculate you are actually just looking at the the property as a whole and estimating the value of it.
When you invest you look into each and every component present in the property its value over depreciation, the current valuation of each machine present, the future valuation of it.
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