Margin of Safety

Monday, January 16, 2017

Margin of Safety

Benjamin Graham had emphasised on margin of safety while making investing decisions. All legendary value investors, including Warren Buffett, Charles Munger, Walter Schloss not only vouch for margin of safety but harp on it.

Why is it so important?

The reason is simple.

History shows that managements of companies, even the best managed ones, often make huge mistakes, harming not only the company’s prospects but seriously impairing the value of investors’ interests.

Besides management mistakes there are many environmental risks – political turmoil, disruptive technologies, etcetera.

When you buy the shares below the intrinsic value, when such a management mistake happens you may exit the investment without a loss or a minimum loss. Whereas the person who had bought the share at a very high premium to the intrinsic value naturally suffers a huge loss.

Investor taking the high risk way

Let us consider the following example:

		Value Investor	High Risk Investor
Intrinsic value of the share	240
Price at		192	434
Price after a serious disastrous event	200
Profit/ (Loss)		8	-234

In investing the golden rule is do not incur a loss.

When one buys a share below its intrinsic value, the gap provides the margin of safety. The price difference of Rs.40 provided a 16.67% margin of safety to the value investor, which helped to exit the investment at a low profit of Rs.8 whereas our high risk taking investor had to suffer a huge loss of Rs.23k!