Investing is fraught with numerous risks and perils. An investor has to contend with corporate news flow, industry updates and expectations set by analysts who cover a stock.
The legendary value investor Benjamin Graham coined the term “margin of safety” when he evaluated companies as investments. In essence, Graham was looking to minimize the chances of losing money and ensure one can sleep soundly at night.
But what exactly is a margin of safety and how can we assure ourselves that our investments possess this trait?
Think of a margin of safety this way: when you build a bridge which regularly has twenty-ton trucks driving over it, you want to ensure it can take a higher load — perhaps up to forty-tons — rather than just designing the bridge to be able to withstand exactly twenty tons. This analogy is useful when applied to investing – we want to ensure that should something negative occurs to our companies, we would be able to withstand the shock and not lose too much money.
It is important to note that it is almost impossible to avoid losing money when we invest.
Even the best investors in the world such as Warren Buffett and Seth Klarman have lost money on their investments. No one is perfect as the future is always uncertain. The purpose of the margin of safety is to minimize the losses from poor investments and to ensure our overall portfolio generates a decent return above inflation.
A margin of safety can be obtained by buying companies cheaply according to traditional measures of value, such as the price-earnings ratio or the price-to-book ratio.
The idea should be that even if something unexpected occurs or if the thesis should prove wrong, the investor would not lose a large amount of his capital. Doing proper due diligence on an investment idea also reduces the risks of getting things wrong, and controlling our emotions and being cognizant of our psychological biases helps in ensuring we do not simply jump into an investment without first researching it. I will be writing an article soon on how expectations can influence valuations and share price, therefore an investor should be wary of optimism as it can make shares expensive and reduce one’s margin of safety.
The above are several methods that investors can use in order to establish a requisite margin of safety in their investments. By focusing on protecting our downside, the upside can naturally take care of itself.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.