Savvy Investors Factor in a Margin of Safety
As an investor building retirement savings, it’s wise to err on the side of caution in your projections by building in a “margin of safety”. The concept is well-known in accounting and among a brand of investment professionals known as value investors. But it should also apply to your savings, because it substantially lowers your risks, or chances of loss.
A margin of safety in accounting refers to the cushion or buffer zone a company has between its current or projected sales and the level of sales at which it would begin to incur a loss – the breakeven point.
As an investment concept, margin of safety is associated with the value style of investing and was coined by the father of value investing, Benjamin Graham, in his famous book “The Intelligent Investor”. It refers to building in a buffer zone when considering buying an asset (typically a share) to protect against loss, but also, importantly, to improve the chances of success.
The value style involves buying shares when they are trading below their fair value with the assumption that they will revert to fair value (see “Growth, Value and Quality: Investment Styles You Should Know”). The margin of safety is the difference, expressed as a percentage, between a share’s current market price and its fair, or intrinsic, value, which is determined by an objective appraisal of the company’s performance and profitability. The share may rarely trade at its fair value, being either overvalued or undervalued by the market. But over time, the price should converge on this value, according to the value investment philosophy.
The issue is one of probabilities – what is the probability of a share’s price going up rather than down? If the share price is below fair value, the probability of it rising is greater than the probability of it declining further, and the bigger the difference, or margin of safety, the more extreme these probabilities become. The opposite also applies: the further above fair value a share is trading, the more likely it is to drop in price. That’s not to say that high-probability outcomes will happen, or that low-probability ones won’t; it’s just the best you can plan for.
American investment professional and finance writer Morgan Housel elaborates on this in his book “The Psychology of Money”. He gives the example of card counters playing blackjack. By knowing what cards have already been played, they improve the odds of anticipating what card will be played next, even though the odds remain small. “The strategy works entirely on humility – humility that they don’t know, and cannot know exactly, what’s going to happen next, so they play their hand accordingly,” Housel says. “The card counting system works because it tilts the odds ever so slightly from the house to the player.”
Housel says you can apply this principle to financial planning. He says it’s impossible to predict with any certainty the returns on your investments over the next 10 years or the amount you will have saved by retirement age. “The best we can do is think about odds,” he says.
You can get an estimate of your retirement lump-sum based on past average returns. But what if future returns are lower or your target retirement date falls in the middle of a market crash?
Housel says the solution is two-pronged: lower your investment risk by diversifying a portion into lower-risk investments such as bonds (this is an in-built feature of savings in retirement funds), and factor in room for error (margin of safety) when estimating your future returns.
He personally works on the assumption that his returns will be one-third lower than the historical average. “The future may be worse that one-third lower than the past, but no margin of safety offers a 100% guarantee. A one-third buffer is enough to allow me to sleep well at night. And if the future does resemble the past, I’ll be pleasantly surprised,” Housel says. In the words of Warren Buffett’s late fellow investor Charlie Munger: “The best way to achieve felicity is to aim low.”
