What is the safety margin?

Definition and Examples of Margin of Safety

The margin of safety is the difference between a stock’s intrinsic value and its market price. It is considered one of the fundamentals of value investing, which is an investment philosophy that focuses on selecting stocks that are significantly undervalued by the market.

How Does Margin of Safety Work?

Benjamin Graham, the father of value investing and mentor to legendary investor Warren Buffett, created the concept of margin of safety. In his book “The Intelligent Investor” published in 1949, Graham wrote: “The margin of safety depends always on the price paid. It will be large at one price, small at another, and nonexistent at a somewhat higher price.”

Advantages and Disadvantages of Margin of Safety

Explained Advantages

Creates room for error: Investing in stocks with a margin of safety provides you a cushion in case you are wrong. Helps you account for different types of risks: To create a sufficient margin of safety, you must consider various types of risks, including risks related to the company itself, the stock market as a whole, and errors in your estimation of the stock’s intrinsic value. Prevents you from joining the herd: Many investors end up paying high prices for stocks because they invest according to the latest trend. Investing only when you see a wide margin of safety helps avoid making investment decisions based on hype.

Explained Disadvantages

Depends on subjective factors: The margin of safety requires calculating the stock’s intrinsic value, which can vary significantly depending on the approach and individual investor. Does not guarantee returns: Investing using margin of safety is an important risk management technique, but it does not eliminate risk. Even a wide margin of safety does not guarantee that you will not lose money. Furthermore, investing with a margin of safety that is too wide can reduce your returns. Less suitable for growth investors: A wide margin of safety is considered less important for growth investors who wish to accept greater risks for larger returns. Calculating the intrinsic value of companies in emerging industries can be challenging. However, growth investors are less concerned about finding a cheap deal and more interested in maximizing their returns.

What Does This Mean for Individual Investors

The appropriate margin of safety for you as an individual investor largely depends on your risk tolerance and investment style. If you are concerned about minimizing risks, you may target a margin of safety of 20% or more. However, if growth is your primary goal, a narrower margin of safety may be suitable.

Sources

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Benjamin Graham. “The Intelligent Investor, Revised Edition.” Chapter 20, page 512. (Download required.) Accessed June 15, 2021.

SoFi Learn. “Understanding Margin of Safety.” Accessed June 15, 2021.

My Accounting Course. “Margin of Safety.” Accessed June 15, 2021.

Source: https://www.thebalancemoney.com/what-is-margin-of-safety-5189021