The Role of Safety Margins in Successful Investment Strategies

There is no secret that investing is a risky business. If you lose your money on a bad investment, it may
take years to get back to the same financial level if that ever even happens. Therefore, both professional
and amateur investors look for ways to control the damage in case of a wrong financial move. This can
be done by adopting a systematic strategy and avoiding rash and emotional decisions. An important
part in the methodological approach to investment is played by determining the safety margins on the

What is a margin of safety?

There are two main meanings of safety margins that one will encounter in business and finance. In
accounting, the most important variable recognized as safety margin is the difference between actual
sales and the sales at the break-even level. In other words, the figures expressing how much your
company’s sales can decrease before it starts to work unprofitably is your margin of safety.

The other meaning of the safety margin, the one that we will concentrate on in this article is crucial in
investment, especially value investing. Here, the safety margin is the difference between the stock’s
intrinsic value and the target price at which you would be willing to buy it.
The idea of the margin of safety was popularized by the legendary investor Benjamin Graham who is
known as the father of value investing. As such, it is primarily used in value investing to mitigate the
risks involved in it.

The general idea is simple enough. If you are interested in buying the stocks of a particular business,
you look into how much its stocks are worth intrinsically. For example, you might determine, that even
though the current price of the stock is 50 dollars, it is actually worth around 80 dollars. In this case,
the 30 dollars by which the stock is underpriced is your safety margin. Given the stock’s intrinsic value,
you can bet on its rising in the future as more likely, even though you do not know what sort of market
fluctuations lie ahead.

On the other hand, if the same stock is currently priced at 100 dollars, you might not be interested in it
until it falls at least to 65 dollars. In this case, you set your target buying price 15 dollars below the
stock’s intrinsic value to have that difference as your safety margin.

Thus, the key notion behind safety margins is that the market is unpredictable and not perfectly stable
so it can price stocks well above or below their value. Therefore, instead of looking at the way the
market prices stocks, you first look at the intrinsic value of the business. This value gives you some
stability in the long term. You can then set your own target price with an adequate safety margin to
minimize the probability and gravity of loss on investment.

Determining the intrinsic value of the stock

The important role of safety margins as insurance against big financial loss is pretty clear. However,
whether this insurance works as it should depend on how accurately the intrinsic value of the stock is
determined. If you are wrong about the real value of the company, you are wrong about your safety
margin when setting the target price.

This is where things get tricky. There is no encyclopedia or any other objective source to tell you what
exactly a stock is truly worth. It is the job of the value investor or the financial firm to make that
determination. And as with any other subjective evaluation, this one is prone to errors and wrong

Increasing the probability of making the right assessment when determining intrinsic stock value
requires extensive research. That is why investors take their time when evaluating particular
businesses. They tend to look at the historical trends within the entire industry and investigate every
aspect of the business in question.

The main asset that financial firms and investors have in their quest for intrinsic stock value is data.
Analysts look at both historical data and alternative data that is available today to make sure that they
know everything about the company of interest. Thorough data analysis is what helps them to assess
the value of the stock as accurately as possible and thus set the right buying price with adequate safety

Playing the long game

The whole point of paying attention to safety margins and stock’s intrinsic value instead of its current
price is the goal to win in the long run. Deciding to invest only with sufficient safety margins means
that oftentimes you will not be buying stocks that are on the rise at the time.
Thus, you will pass on making a quick buck at the same time passing on taking the high risk. What you
aim at is winning the long game.

Related Articles

Back to top button