The Casino

For every game there are two sides: the player and the owner. Both sides are attempting to make money from the same game. For the player, it is entertainment but for the owner it is a business. What separates the two are the odds or the margin of safety. For the player it is against him. For the owner it is with him. If the player forgets this fact, he courts disaster. If the owner forgets this fact he may behave foolishly and, therefore, not do as well as he could.

The analogy describes the difference between the speculator(player) and the investor(owner).

Price is what you pay, value is what you get.

When you buy a stock there are three things that determine ultimate success:

What you buy?
Buy stocks that you know will be significantly larger over the long run.

How you behave?
Look at the business not the market and make sensible decisions.

What price you pay?
Look for a margin of safety.

Focus on the emotional cycle

The market goes through four emotional cycles :

Pessimism, Skepticism, Optimism and Euphoria

Market commentators during times of pessimism and skepticism tend to advise their pubic that they should trade the market. Articles appear about how the buy and hold strategy is dead. The rapid swings of the market make their arguments convincing and because the period is characterized by a great deal of fear, the strategy offer's a feeling of safety and for a few profitability. In reality thou executing successfully is almost impossible. The irony about the advise is the fact that stocks offer the greatest margin of safety during these periods. Just about nothing creates the best prices then fear. It is precisely during these times that the buy and hold strategy should be applied.

Optimism and euphoria have the opposite effect. Stocks lose their margin of safety due to inflated prices. It is because foolishness can go on for what feels like eternity, especially if you are out of the market, that the buy and hold strategy takes hold backed by advice from those in the know. In reality the sensible thing to do, during this period, is to sell and trade. By reducing stocks and moving into other assets you then prepare for the eventual decline.

Warren Buffett has called derivatives "weapons of mass financial destruction" but then he went and wrote a whole bunch of derivative contracts. Is he being disingenuous?

On the surface the answer is yes. If you look at it from the point of view of the 'margin of safety', the concept Buffett learned from Benjamin Graham, the answer is no.

The derivative positions are "put options" on at least three world wide Indexes. This means that for an up front fee, Berkshire will pay out a very large sum of money, many years from now on a particular day, if the indexes are below a specific value on that day. That specific value is called a strike value. Unlike the derivative contracts written by AIG there is no requirement to post a collateral if the "mark to market" value varies which almost surely it will. Collateral in finance means a security or guarantee (usually an asset) pledged for the repayment of a loan. In this case it's cash. The term "mark to market" means the contract is given a value daily even thou the contract matures many years from now. Having to payout a collateral pushed AIG into bankruptcy.

Furthermore, to completely lose all the money, all three indexes would have to go to zero. It just won't happen.

All these factors : 1. the lack of collateral required 2. the time to maturity 3. multiple indexes 4. the choice of indexes 5. the up front fee all constitute a "margin of safety".There is one other "margin of safety" not so obvious and that is of a manager that has both the experience and good judgment backed by a sound mental framework for decision making.

Perhaps the analogy is the use of explosives. If used without skill, experience and good judgment, it could blow up in your face. But used with skill and only in selected situations such as demolition it is the only solution.