Investing in shares is different from placing a bet when an investor studies the business, weighs the price against a reasoned estimate of value and accepts that the outcome is uncertain. This guide explains three ideas often linked to Warren Buffett’s approach: owning businesses through shares, treating market prices as offers rather than instructions, and leaving a margin of safety.
A share represents ownership in a business
A share is a security that gives its holder an ownership interest in a company. That does not mean every company is well run or that every share is worth its current price. Investors still need to examine the company’s products, finances, competition, debt, management and risks.
Over time, business performance can influence what investors are willing to pay, but share prices do not follow earnings in a precise or predictable way. Prices also respond to expectations, interest rates, news and changing investor views. A sound business can still be a poor purchase at an excessive price.
Mr. Market is a metaphor, not a forecast
Benjamin Graham’s Mr. Market is an imaginary business partner who offers to buy or sell each day at a different price. Some offers may look attractive; others may not. The point of the metaphor is that a quoted market price is an offer to consider, not a command to trade.
It does not follow that a falling share price is automatically a bargain or that a rising price is automatically a reason to sell. The investor still has to revisit the business and the assumptions behind its estimated value.
Use a margin of safety—and remember that estimates can be wrong
A margin of safety means paying meaningfully less than a conservative estimate of a business’s value. The gap is intended to provide some room for mistakes in the analysis or for unexpected events. Buffett wrote that the principle, emphasized by his teacher Ben Graham, is central to investment success.
Intrinsic value is an estimate, not a number that can be observed exactly. Different assumptions about future cash flows, competition and risk can produce different estimates. A margin of safety does not prevent losses and cannot make an uncertain valuation certain.
Quality and price must be considered together
A strong company may be overpriced; a low-priced company may have serious problems. Before making an investment decision, an investor can ask what the business does, how it earns money, what could weaken it, how much debt it carries and what expectations are already reflected in the share price.
Long holding periods do not guarantee high returns. In Berkshire Hathaway’s 1997 letter, Buffett and Charlie Munger noted that they would not outperform an index every year and described the S&P 500 as a benchmark for assessing performance. Results depend on the businesses owned, purchase prices, costs, taxes and the period measured.
How to use these ideas
- Read the company’s disclosures and understand the business before focusing on its ticker or recent price movement.
- Write down the assumptions behind any estimate of value and consider how the result changes if those assumptions are wrong.
- Compare the price with that estimate, while remembering that an estimate is uncertain and no margin of safety guarantees a profit.
- Consider diversification, time horizon, fees and the possibility of losing money. No single philosophy is suitable for every investor.
Frequently asked questions
Does owning a share mean the company will make me money?
No. A share is an ownership interest, but its price can fall and a company may perform poorly. Dividends are not guaranteed.
Is Mr. Market a signal to buy when prices fall?
No. It is a reminder to assess an offer independently. A lower price does not, by itself, show that a business is undervalued.
Does a margin of safety remove investment risk?
No. It is a way to account for uncertainty in an estimate. The estimate may still be wrong, and the investment can lose value.