Professor Sanjay Bakshi, a well-known academician in the field of value investing and behavioural finance, has drawn comparisons between driving and investing.

Bakshi, a Managing Partner at ValueQuest Capital LLP and now Adjunct Professor at Pune-based FLAME University, compared the margin of safety with the distance between two cars.

“One measure that comes to mind immediately is the distance, the gap between your vehicle and the vehicle ahead of you, and you want to keep that large, you don't want it to be too small and that number, that distance is a variable,” Bakshi said on the concept of margin of safety in a 15-minute video.

So for instance, the distance would be different depending on the speed you were going at. It would also depend on the terrain you were driving in. So if there is a heavy vehicle ahead of your car on an uphill road, you would keep a bigger distance than if you were behind that vehicle on a level road.

In investing, that distance is the value of the business and the price you are willing to pay for it. The ideal thing would be to buy a business for less than what it is worth. Occasionally, one may get away by paying slightly higher than what the business is worth. But if you overpay for the business by a wide margin, there is a high probability that your returns will suffer.

The second metaphor Prof Bakshi used was the steering wheel, more specifically, driving as if there was a dagger on the steering wheel pointing to your heart.  It has also been used by Buffett in the past to explain highly leveraged capital structures.

Leverage is the amount of debt a firm uses to finance its assets and is the dagger in this example. Bakshi said most individuals would drive more carefully with a dagger on the steering wheel than in its absence. Similarly, in the case of a highly leveraged company, management will perform more efficiently because of the explicit risk of debt (the dagger).

“You have to return the money and you have to service the debt. So the incentive effects of leverage are well recognised,” he said, comparing equity to a ‘soft pillow’ and debt to a dagger in the steering wheel.

Bakshi's next analogy is risk aversion and jumping traffic lights. He highlighted how several psychological factors are at play in both situations. He said many people take risks because they fear missing out on a narrow window of opportunity and when faced with information about the risk they commit subjective fallacy by believing that the risks (loss of investment, car accidents) do not apply to them even if they are real.

“While driving, the obvious thing is, if you come across a green light, you keep driving. But if I see a green light turning to yellow, I am expected to slow down and apply the brakes.

But, that’s not what we usually do, do we? Our common tendency when we see the light turning green is to accelerate, instead of decelerating,” Bakshi said.

People want to avoid losses, he said, so they respond to losses and perceived losses. In this case, the loss is the lost time if the light turns yellow. So they see a small window to race through the light, and they think and believe they can do it.

The second reason was overconfidence. People know racing through yellow lights increases the chances of accidents. “The risk is much higher and the logical thing to do is slow down and to stop. But that is not what most people do,” he said because they are overconfident.

“Overconfidence comes from the idea that, well I know this risk exists, but it doesn’t apply to me. It applies to other people,” he explained.

We see variants of this behaviour a lot in the business, he said. People think, this happens to other people, it doesn’t happen to me and that is not true.

The final example was that of the rear-view mirror.

“When we look at the windscreen, we look at the now, and likewise when you look in the rear-view mirror, you are looking at the past,” he said.

“When we build our models, we think about valuation, meaning we think about the future. And one way to think future is to look in the past or the rear-view mirror. Maybe it is reliable, may it is not, but while driving you got to look at the rear-view mirror and think of the future, he said.