Before deep-diving into the concept, let us first see what the top investors of the world say about the idea.
Benjamin Graham – A great American Investor also known as the father of “Value Investing.” quotes in his famous book “The Intelligent Investor” chapter no. 20 “we venture the motto, MARGIN OF SAFETY.“
Warren Buffett – One of the most successful investors in the world quotes “Margin of Safety are the three most important words in investing”
Lastly, Seth Klarman – is an American billionaire investor, hedge fund manager, and author quotes Margin of Safety as “A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.”
Definition: Margin of Safety (MoS) is the principle of investing in which an investor only purchases securities when their market price is significantly below their intrinsic value.
Graham on Margin of Safety – Graham explains MoS as, if a stock which is priced today at $1 can be either valued at 50 cents or 1.5$ in the future, he also says that buying at $1 is also an unnecessary risk. He believes that if we can buy the stock below its intrinsic value i.e at 50 cents, the losses will substantially decrease in comparison to buying the stock at $1, thus the MoS would ensure him that his losses are minimal.
Graham says that there are some risks that we are always unaware off, he used to refer those risks as “Unknown – Unknown”. These risks can be only controlled by Margin of Safety concept.
Why the Margin of Safety so important?
Stock markets are volatile (with a large upside followed by a downslide within moments in a single day) the rate of stock can skyrocket at one time and can rapidly come down in a single day. Since time immemorial, it is only a high MoS that can protect you from making extreme losses in this kind of market volatility.
Also, in case if an investor misjudges the value of a company, a high MoS would always protect him from huge losses.
Warren Buffett has a very simple analogy to explain the very concept. He refers to the MoS concept with the concept of a bridge. Whenever we construct a bridge the engineers would always consider various factors of safety; it should be strong enough to bear a load of a 30-tonne truck even though we know that trucks of 10 tonnes would only be running on it. This is what MoS is all about it provides a cushion while investing since the process of investing involves various risks and imperfect information. Buffett himself says that it is impossible to get it all right when you are talking about the future. This is where the concept of MoS comes in handy.
Essentially, a higher MoS will always reduce your investment risk. But the risk will always exist and managing this gap is what smart investing is all about.