Margin of Safety

Why understanding this concept is more than an investment safety net

The investment world is full of platitudes and fads. There’s always some new way to better value a company or to pick the next 10 baggers but for those that understand the Lindy effect (don’t worry if you don’t just look it up), you’ll understand that what’s been around for a long time is more likely to be around in the future.

The margin of safety concept is one of them.

In the investment world, a margin of safety was attributed to and used very well by the legendary value investor Benjamin Graham. He believed in buying assets worth $1 for 50 cents. Very much easier said than done. He did this because he knew the intrinsic value of the company when others did not and knew it was only a matter of time before the market re-adjusted the price. This is usually the point most normal people notice (when it’s too late).

Now, just understanding the intrinsic value of a stock is a hard thing to do because it’s inherently subjective. There are now hundreds of books and courses on how to value stocks at their intrinsic value but it’s so easy to get it wrong. When you get it right though the potential for upside is unparalleled.

For those of us who are not geniuses though this is where understanding and deploying a margin of safety can offer us some protection. Let's say you do some diligent research on a stock, and you believe it’s unfairly priced by 10%. You could just dump your ISA savings into it or, you could say to yourself hang on a minute, there’s a chance I’m wrong here, let’s wait for it to come down another 15%. The problem is it may never come down another 15%. In fact, it could also never drop that low again and you’ve missed your opportunity.

This is frustrating and is something I’ve personally had happen to me and it can leave you a bit peeved off with yourself. The opposite of this has also happened to me as well where I’ve jumped into buying a hype stock only to see the price fall and fall and fall.

Maybe you know how to value a stock or maybe you don’t but if you give yourself a margin of safety, you’re giving yourself a better chance of future earnings. As Warren Buffett said:

“The first rule of an investment is don’t lose money. The second rule of an investment is don’t forget the first rule.”

How much of a margin of safety depends on your appetite for risk and how patient you are. As a rule of thumb, I like around 30% and while opportunities seldom come by at such a discount one thing that’s been very easy to see the last few years is that stock prices can drop a hell of a lot when there’s a global event such as the pandemic, or a war such as the one in Ukraine. Interest rates and inflation have hurt stocks, particularly in the U.K. also offering opportunities but be aware of value traps. If a stock is at a 3-year low, it may be undervalued, or it could be valued fairly. Margin of safety is a tool to be used alongside other tools such as valuing stocks at their intrinsic value and not to be used in isolation.

A good way of better understanding a margin of safety is to use it in everyday life, especially outside of investing. We do this all the time, subconsciously or consciously. You’re planning a trip abroad and to get there you may have to go to the airport to catch a flight. Typically, in the U.K. you arrive at the airport no later than 2 hours before your scheduled flight to a country outside of the U.K. and an hour if the flight is internal. Most sensible people will check how long it takes to get to the airport and add that to the 2 hours. Depending on what time your flight is you might also err on the side of caution. If your flight is at 5 pm you can be sure that they’ll be more traffic. So, what do you do? You add a margin of safety. What usually might be a half-hour drive might take an hour in traffic, so you add it to your time. If you get there early so what? If you get there late? You’re fucked mate :(

You’re having some friends over for a BBQ. Not only are BBQs great but in Manchester, they are also a rarity because of the shitty weather (nobody wants to be that guy cracking the coal out when the cloud breaks away for a split second when it’s 14 degrees). You’re in the supermarket picking up food and booze and trying to work out how much you’ll need and what do you usually do? You overcompensate because nobody wants to be that guy who invited everyone around to a BBQ only to run out of food or worse, booze.

Put another way, you gave yourself a margin of safety.

My job is in construction and I’m in charge of running construction sites. Part of my job is to come up with a programme from the first day the new job starts to when our contractual completion date is. Within that programme are all the large, medium and tiny bits of work that have to be done. Do you think I plan it all out working perfectly? I’d be mad too! I add as much of a margin of safety as I can get away with. Too much inflates the programme, and the client might give the work to somebody else but with too little I run the risk of chasing my tail for the whole job (quite often the latter happens as most people either want something for nothing or they want it yesterday).

The concept of margin of safety is easy to understand but it’s the practice and patience required to ignore all the noise around you that takes the real skill. Patience is a virtue here. Lastly, I’ll leave you to ponder this:

Humans are inherently bad at judging and predicting things and if you’re somebody that disagrees with that comment, then perhaps 30% isn’t a big enough of a safety net for you.