Investment decisions are subject to error due to cognitive biases of the decision makers. One method for preventing cognitive biases from influencing decisions is to specify the algorithm for the decision in advance and to apply it dispassionately. Heuristics are useful practical tools for simplifying decision making in a complex environment due to uncertainty, limited information and bounded rationality. We develop a simple heuristic for making value investing decisions based on profitability, financial stability, susceptibility to bankruptcy, and margin of safety. This achieves two goals. First, it simplifies the decision making process without compromising quality and secondly it enables the decision maker to avoid potential cognitive bias problems.
Value investing is an investment paradigm proposed by Benjamin Graham (Graham and Dodd [1934], Graham [2006]). According to Graham and Dodd [1934], “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
There are three essential components of this definition to take note of. First, an investment must be based on thorough analysis; second, it should have an assurance of safety of principal; third, it should entail an expectation of satisfactory return. Benjamin Graham further proposed the concept of “margin of safety” as the cornerstone principle for operationalizing this definition of investment. Margin of safety is a measurement of the degree to which an asset is trading at a discount to its intrinsic value. It is pretty straightforward to see how “margin of safety” relates to Benjamin Graham’s definition of investment. Thorough analysis enables the investor to obtain an estimate of the intrinsic value of the asset and buying it at a substantial margin of safety ensures safety of principal as well as reasonable expectation of satisfactory return. Since intrinsic value is difficult to calculate accurately, margin of safety provides a cushion against making any poor decisions.
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