Lesson #9: Insure Your Investments With a Margin of safety

Before we move ahead into this ninth lesson, just answer Yes/No to these five simple questions:

  1. Do you own an insurance policy?
  2. Do you save money?
  3. Do you keep extra cash (more than you will need) with you when you travel?
  4. Do you reach the railway station an hour before the scheduled departure of your train?
  5. Do you believe that prevention is better than cure?

If you answer ‘Yes’ to all or most of the above questions, you are a practitioner of ‘margin of safety’.

You keep some extra time and money on your hand in case things do not go as planned – like if you run out of cash during your travel, or you get stuck in a traffic jam while going to the catch a train.

The same ‘margin of safety’ applies even to stock market investing.

In fact, these are often considered the three most important words in investing.

Margin of Safety

The principle of margin of safety in investing was first introduced by the ‘father of value investing’ Benjamin Graham.

In simple terms, for stocks…

“Margin of safety if the difference between the intrinsic value of a stock and its market price.”

This principle suggests that you must buy a stock only when it is worth more than its price in the market.

So if a stock is trading at Rs 100 in the market, and you calculate the company’s intrinsic value as Rs 150, you have a margin of safety of Rs 50 (150 minus 100). In other terms, the stock is trading at a 33% discount to the company’s intrinsic value.

If the said stock is of a high quality company, it is advisable to buy it at any price that is 80% or lower than the company’s intrinsic value (any price lower than Rs 120).

And if the said stock is of a company that is not an exceptional one (but worthy enough for investment), you must not buy it for more than 50% of the intrinsic value (only if the price is lower than Rs 75).

“What margin of safety does is that it protects you from poor decisions and downturns in the market.”

So if you pay just Rs 100 for a stock that you believe is worth Rs 150, even if your analysis goes wrong and the stock is actually worth less than Rs 150, your investment will still be safe.

Given that the calculation of intrinsic value (of Rs 150 in this example) is subjective in nature, it is always better to have a good margin of safety while buying a stock. A 30-40% margin of safety is what Graham recommends.

This disciplined pursuit of bargains (stocks that are available for 30-40% less than their intrinsic values) makes value investing very much a risk-averse approach.

But the greatest challenge for you as an investor is to maintain that required discipline.

The trap of a rate race
Most of us generally fall in the trap of following the herd. So we buy stocks when the prices are rising, just because we do not want to miss out on the paper profits that our friends, colleagues, or relatives are making by betting on rising stocks.

But then, being a value investor means standing apart from the crowd, and challenging conventional wisdom.

It can be very lonely being a value investor practising a concept like margin of safety.

But if you can do it with utmost discipline, you can earn great returns from the stock markets over the long run.

With respect to margin of safety, here is what Warren Buffett, whom Graham considered his best student, has to say:

“We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”

Buffett describes margin of safety concept using this example – “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”

How much margin is good margin?
Coming again to the question of what is an adequate margin of safety, the answer varies from one investor to the next. But it chiefly depends on –

  1. How much bad luck are you willing and able to tolerate?
  2. How much volatility in business values can you absorb?
  3. What is your tolerance for error?

In short, it all boils down to how much you can afford to lose.

Losing some money is an inevitable part of investing. In fact, there is nothing you can do to prevent it.

But to be a sensible and intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money.

Using the margin of safety concept, and by refusing to pay too much for an investment, you minimise the chances that your wealth will ever disappear or suddenly be destroyed.

To conclude, as Graham reminds us, the intelligent investor must focus not just on getting the analysis right. He must also insure against loss if his analysis turns out to be wrong – as even the best analyses will be at least some of the time.

So that was about margin of safety. You now know its relevance, right?

In the next (tenth) lesson, we will talk about a weird creature called Mr. Market, who with his ever-changing moods, lures investors to make big investing mistakes.

But there is a way you as an investor can protect yourself from the whims of Mr. Market. We’ll find ‘how’ in the next lesson. So stay tuned.

P.S.: Got here via a link from a friend, or a forwarded email? This is the ninth lesson of the 20-lesson free email course on the essential pillars of becoming a successful investor, Safal Niveshak-style. We talk about simple investing strategies that will work for you, and make you a smarter and successful investor.

Learn more about the course or simply sign up here.