Thursday, 16 August 2012

Actuarial Investing. Benjamin Graham's investing was actuarially based.

When Warren Buffett started investing, his approach was very different from the one he follows today.  He adopted the method of his mentor, Benjamin Graham, whose system was actuarially based.

Graham's aim was to purchase undervalued common stocks of secondary companies "when they can be bought at two-thirds or less of their indicated value."

He determined value solely by analysing publicly available information, his primary source of information being company financial statements.

A company's book value was his basic measure of intrinsic value.  His ideal investment was a company that could be bought at a price significantly below its liquidation or break-up value.

But a stock may be cheap for a good reason.

  • The industry may be in decline,
  • the management may be incompetent, or 
  • a competitor may be selling a superior product that's taking away all the company's customers - to cite just a few possibilities.  
You're unlikely to find this kind of information in a company's annual report.

By just analysing the numbers Graham could not know why the stock was cheap. 

  • So some of his purchases went bankrupt: 
  • some hardly moved from his purchase price; and 
  • some recovered to their intrinsic value and beyond. 
Graham rarely knew in advance which stock would fall into which category.  

So how could he make money?  He made sure he bought dozens of such stocks, so the profits on the stocks that went up far outweighed the losses on the others.

This is the actuarial approach to risk management.  In the same way that an insurance company is willing to write fire insurance for all member of a particular class of risks, so Graham was willing to buy all members of a particular class of stock.

An insurance company doesn't know, specifically, whose house is going to burn down, but it can be pretty certain how often it's going to have to pay for fire damage.  In the same way, Graham didn't know WHICH of his stocks would go up.  But he knew that, on average, a predictable percentage of the stocks he bought would go up.

An insurance company can only make money by selling insurance at the right price.  Similarly, Graham had to buy at the right price; if he paid too much he would lose, not make money.

The actuarial approach certainly lacks the romantic flavour of the stereotypical Master Investor who somehow magically, only buys stocks that are going to go up.  Yet it is probably used by more successful investors than any other method.  For success, it depends on identifying a narrow class of investments that, taken together, have a positive average profit expectancy.

Buffet started out this way, and still follows this approach when he engages in arbitrage transactions.  it also contributes to Soro's success: and is the basis of most commodity trading systems.

AVERAGE PROFIT EXPECTANCY is the investor's equivalent of the insurer's actuarial tables.  Hundreds of successful investment and trading systems are built on the identification of a class of events which, when repeatedly purchased over time, have a POSITIVE AVERAGE EXPECTANCY OF PROFIT.

Ref:  The Winning Investment Habits of Warren Buffett and George Soros by Mark Tier

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