Margin of safety is one of the most important concepts in investing. You get it by subtracting the true value of an investment from its market price. Margin of safety offers the opportunity to reduce the loss of capital by providing room for inaccuracy, bad luck, or mistakes. You need a margin of safety because valuations are imprecise at best, the future is uncertain, and you will make mistakes. Graham based his risk management principles on an adequate margin of safety, careful analysis, and diversification. Using a margin of safety with adequate diversification was his way of approaching investment risks.
It is possible to overpay for any investment. The probability of making a mistake decreases as the price paid decreases. Using a margin of safety does not guarantee success in individual cases. Although the margin is on the investor's side, individual investments can still result in losses. Take advantage of the concept every time you invest. The more assets you use a sufficient margin of safety for, the better the odds are in your favor. This principle also works strongly in the business of insurance companies.
All investments are based on uncertainty about the future. You can’t just focus on analysis. You need to protect yourself from loss if your analysis is wrong. The probability that you are wrong at least once is almost 100%. You can’t control the above factors. You can only control the consequences when you are wrong. That’s what a margin of safety is for. It limits losses. Even the most foolish investors can make money in a bull market, but they will probably lose it in a bear market, along with interest.
Margin of safety and company quality. There are differences in the way companies do business. A higher quality business can cost more. As a result, a slightly lower margin of safety is needed if quality is not taken into account in the valuation. In this case, there is no reason to mitigate the margin of safety. The predictability of companies slightly lowers their margin of safety. Less variable results can reduce the margin of safety. Many investors, such as Warren Buffett, only invest in companies whose results are consistent.
Graham's only starting point for calculating the margin of safety is the company's business income and profitability. This applies to both bonds and stocks. He did not calculate the margin of safety for both in the same way. He used two ways to calculate the margin of safety for bonds. The first way was to calculate how many times the company has made a profit in recent years compared to the interest it has paid on bonds and dividends on preferred shares. The second way was to compare the sale price of the entire company over a few years to its current liabilities. In this case, the sale price meant the market price of publicly listed assets. In the first way, the margin had to be three times. In the latter way, the price could be a maximum of two-thirds of the public listings. The latter method should be used mainly for companies that focus on owning publicly listed securities. Even then, the market price should be close to the total value of the securities.
In his book Intelligent Investor, Graham offers several options for calculating the margin of safety. When evaluating individual stocks, an investor should use a larger margin of safety than when creating a diversified portfolio. He calculated the margin of safety for an individual company by comparing the company's earnings yield to the interest paid on its potential loan. With an earnings yield of 9% and an assumed interest rate of 4%, the interest paid is 44% of the earnings yield, which provides a sufficient margin of safety. When an investor buys 20 different stocks, the margin of safety can be lower. In addition, Graham used a margin of safety, which he calculated from the balance sheet value, to create a diversified investment portfolio.
Many investors use too small margins of safety when buying stocks. I myself have been guilty of this mistake several times. The margins of safety used by top investors are larger than what most people use. Buffett's example of a sufficient margin came from the purchase of the Washington Post, when he had calculated the total value of the company at 400 million and the company's market price was 80 million. At that time, the market price was 1/5 of the value. In 1994, Buffett's partner Munger said that 1/3 of the real value is a safety margin that is enough for an old alcoholic. Philip Fisher talked about rational purchases when the market price of a company was 25% of its value. He did not directly talk about the safety margin.
In addition to using a margin of safety, you need to realistically assess how likely you are to be right and how you will act if you are wrong. Ask the following questions:
How much have I lost in the past when I was wrong, i.e. how much can I afford to lose?
How have I reacted to losses mentally? Have I panicked when I am losing?
Do I have other investments that will make me money when I lose this money?
Am I putting too much money into this investment? Can I afford to lose my money?
It is difficult to recover lost money. When you lose, you have to win a higher percentage than when you lose. When you lose a quarter of your money, you have to make a third of your money back to get back on your own. When you lose half of your money, you have to double it. Losses come much faster than gains.
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