Notes, Views, and the Occasional Provocation September / October 2008  

We're in the midst of an equal-opportunity financial crisis that's hurting rich countries and poor, hedge funds and state pension plans, the banks and all the banks' customers. Warren Buffett recently penned a New York Times op-ed piece explaining why current conditions have produced the buying opportunity of a lifetime.1 Yet prudent investors reasonably ask, Why should they stick around?

We address this question below. We also introduce our newly created blog at http://www.benningfieldadvisors.com/blog.

Please pass along the newsletter to anyone who might enjoy reading it.

Warm regards,

Milo Benningfield



Margin of Safety
Financial bubbles are as endemic to capitalism as the flu virus is to humanity. But lately the epidemics seem to come with increasing frequency and intensity. more

BFA Notes & Media Quotes
Our new blog. more

Recent media quotes. more





Margin of Safety
Financial bubbles are as endemic to capitalism as the flu virus is to humanity. But lately the epidemics seem to come with increasing frequency and intensity. Within the past ten years alone, we've had the tech bubble, housing bubble, and now the credit bubble, prompting one observer to write, "The bubble cycle has replaced the business cycle."2

Financial bubbles might not feel so bad if they took down only the "bad guys" who speculated and lost. But when the neighbors down the street have to turn in their keys to the bank and weeds start spreading across front lawns, your house, too, can fall thirty percent.

Most recently, with the credit crisis, it's been the banks, hedge-fund managers and other sophisticated investors borrowing many times the value of their own assets who created the pandemic. When these players have to raise cash to pay back loans or return money to investors, they are forced to sell off stocks of perfectly good, perfectly profitable companies – the same stocks everyone else owns – causing stock prices to plummet. Add a dose of panic to the mix and we've got the biggest cascade of sell orders to hit Wall Street since the 1930's.

It's probably too soon to talk about the demise of capitalism. Also, one silver lining is that now that everyone's been reminded how risky stocks are, stocks will probably continue to offer investors a higher expected return than safer assets such as cash and bonds. We may get a "new deal" out of the current crisis that will force banks to lend more prudently and avoid all the particular excesses that led to the current crisis.

But all the regulation in the world will not stop the next crisis. Memories will fade, evidence will disappear, and in less than a generation new sins will arise. Warren Buffett's mentor Benjamin Graham observed this fact after another banking crisis back in the 1960's. In that crisis, Graham noted, the bankers and brokers had, indeed, avoided the same frauds and other practices committed in the 1920's and 30's, presumably because they had been criminalized. But, he wrote

It is amazing how, in a completely different atmosphere of regulation and prohibitions, Wall Street was able to duplicate much of the excesses and errors of the 1920s.

No doubt there will be new regulations and new prohibitions. The specific abuses of the late 1960s will be fairly adequately banned from Wall Street. But it is probably too much to expect that the urge to speculate will ever disappear, or that the exploitation of that urge can ever be abolished.3

All this raises the question: if financial bubbles admit no sense of justice, but take down prudent investors along with the gunslingers, why should anyone expose their hard-earned savings to the markets? There are many reasons, but for people destined to live decades, not just years, one of the most compelling is this: inflation.

As the chart below illustrates, even at a moderate rate of 3% inflation, it takes only twenty years– about half a typical retirement – to cut one's purchasing power in half:

Things look even worse when we consider that over the past year general inflation in the U.S. has run well over 5%, and Social Security just announced it will pay a 5.8% cost-of-living adjustment to keep up. At 5% inflation over twenty years, $1,000 today buys only $377 of goods and services tomorrow.

Yes, there are good hedges against general inflation – e.g., Treasury Inflation Protected Bonds (TIPS). But your personal inflation rate is probably higher than the general rate, especially if you live in a large metropolitan area.

So most people need the help of the capital markets and those risky animals called stocks to protect the purchasing power of their future selves. Even if inflation were not a factor, most people cannot save enough over thirty or forty working years to pay for another thirty years of leisure. Without help from the markets, in other words, most people's long-term financial plans just don't work.

But how do we harness the power of the markets without them killing us? Benjamin Graham gave us one tool, a term he coined "Margin of Safety."

It's a straightforward concept: when making calculations about the future, leave some room for error in case we're wrong. As Mr. Graham put it, the margin of safety is "available for absorbing the effect of miscalculations or worse than average luck."4

When applied to stocks, we achieve a margin of safety by purchasing them sufficiently below our estimates of fair value to allow for unusual market conditions or a mistake in our estimates. It is this margin of safety that separates a speculator from a true investor, someone who seeks to be protected against the "vicissitudes of time."5

For individuals with evolving goals, variable health, new family configurations and career transitions as well as a host of other individual circumstances, creating a margin of safety is more complicated, but the basic idea is the same – build some room for error. To do so, we must look beyond stock market valuations to our own financial circumstances in order to determine just how much equity risk we can afford to assume.

Here are some of the key considerations:

An Individual's Portfolio Does Not Live in A Vacuum.
An individual portfolio usually has a finite life expectancy and exists to fund goals with specific time frames and dollar amounts attached. Those parameters determine a lot about how the portfolio must be structured. If you need the money tomorrow or even five years from now, you probably cannot afford the risk of stocks, no matter how "cheap" they look compared to recent prices.

Holding Cash Helps You Hold Your Stocks
With enough cash on hand, both within your long-term portfolio and without in the form of emergency reserves, you're likely never to have to sell your stocks at fire sale prices. With enough cash (and short-term bonds), you sit on the same side of the table as Warren Buffett and opposite the distressed hedge-fund managers.

Pay Attention to Your “Human Capital”
Your willingness and ability to work also affects how much investment risk you can reasonably assume. Before retirement, if your portfolio declines, you can replenish it with increased savings. After retirement, if you can work part time, you can reduce portfolio withdrawals by as much as 25-50%, giving your stocks more breathing room to earn their long-term expected returns.

Know Your Market History
To maintain investment discipline, it helps to know before the journey that you may face disappointments. Even a margin of safety cannot save us from all risks. "For a margin guarantees only that [we have] a better chance for profit than for loss – not that loss is impossible."6

From 1965 through 1981, both the S&P 500 Index and one-month Treasury bills returned roughly the same 6%. Many investors did not make it across this equity desert, and in 1979, BusinessWeek ran a famous cover declaring "The Death of Equities." But from 1982 through 1999, stocks provided triple the return of one-month Treasury bills, over 18% versus 6%.

No one could have predicted those return patterns. But knowing about them encourages us to diversify our portfolios as we move forward, hoping for the best with stocks, but accounting for something worse with cash, bonds, and other assets.

Accept That We Face Risks No Matter Where We Turn
As noted above, inflation is the silent killer that can erode long-term portfolios. But some of us will run out of time before we run out of money, and this mortality risk should be factored into our investment and spending decisions as well.

As Henry David Thoreau put it, "a man sits as many risks as he runs," and the decision to avoid one risk often exposes us to another. Thus, if we choose to seek the assistance of the capital markets, we must be willing to accept the risks involved, if not with pleasure, then at least the same disposition with which we accept the weather.

The current crisis will be resolved, credit will flow again, and stock prices will eventually resume an upward lurch. But most likely the next crisis is already forming in the wings and for that we must be prepared as best we can with our margin of safety.

Where might the next bubble form? If the current housing and credit crises are any guide, it will be a joint effort of government implementing a social policy (affordable housing for everyone) and private actors rushing to help implement that policy (financial innovation, relaxed lending standards). There are probably several good candidates for the role, but at the moment one stands out: alternative energy anyone?

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BFA Notes & Media Quotes
Our New Blog
We're venturing into Web 2.0 and the blogosphere with our new blog called "Margin of Safety." As we develop or come across interesting ideas about investments, the economy, personal finance and other issues, we'd like to share them. A blog will also give us an easy format to take advantage of all the rich media being developed on the Internet, including videos (vlogs), audio recordings (podcasts, etc.) and other interesting materials. We hope you'll enjoy it.

A work in progress, you can see the blog here: http://www.benningfieldadvisors.com/blog

BusinessWeek Online, October 9, 2008
Milo was quoted in Ben Steverman's article, "The Fed, The Crisis, and Your Portfolio," which addressed how to cope with recent market turmoil. Milo noted that because clients' portfolios are well diversified, they haven't experienced as extreme a hit as the equity markets: "A lot of people are relieved to find they have less exposure to 'Wild West' equity markets than they thought they did." Also, a good portfolio structure prevents having to sell at fire sale prices: "'Short-term investors are getting squeezed by the credit crisis,'" Benningfield says. 'But if you're saving for retirement and have enough non-equity investments, "you can afford to wait'." Read the article.

San Jose Mercury News, September 15, 2008
Milo was quoted in Scott Duke Harris's article, "Financial Advisers Calm Worried Clients," noting that diversification is crucial for managing market volatility. Read the article.

The New York Times, September 12, 2008

Milo was quoted in Ron Lieber's article, "Memo to Uneasy Investor: Be Strong." Milo noted there have been a number of reasons for increased market volatility, including increased hedge fund activity; lack of guidance on corporate earnings, and opaque company balance sheets. Further, neurobiology works against us when trying to apply investment discipline: "'We had survival mechanisms built in to avoid sitting around debating whether we should run away from the saber-toothed tiger,'" Mr. Benningfield said. "'That's the fundamental problem with long-term investing. Our skills aren't really that transferable to the challenges involved.'" Read the article.

That's it for now. Thank you for reading. Please look for our next newsletter in December.

Milo Benningfield




1 "Buy American. I Am." Warren Buffett, The New York Times, October 16, 2008.

2 Harpers Magazine, "The next bubble: Priming the markets for tomorrow's big crash." February 2008.

3 The Intelligent Investor, Benjamin Graham, 4th ed. (Harper & Row 1973), p. 125.

4 Ibid, p. 279.

4 Ibid, p. 278.

6 Ibid, p. 282.

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