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Margin of Safety

A simple example given by Benjamin Graham illustrates the concept of margin of safety: a bridge designed to carry trucks up to 10 tonnes should, in theory, be able to withstand the weight of a 10-tonne truck. However, this doesn’t leave much room for error in case of engineers that erred slightly in their calculations, or time that has weakened the structure, and so on. In contrast, a 5-tonne truck should easily make it to the other side.

In stocks, our main protection is in the price we pay. We can’t influence how companies will develop. A myriad of unexpected events, including economic and political factors, or natural causes, can impact their value. Crucially, however, we have full control over the price at which we buy. If this price is sufficiently low versus the estimated intrinsic value of a company, many negative scenarios can materialize but the investment would still be protected by our margin of safety. This, we believe, provides peace of mind to investors.

In addition to offering protection, a margin of safety in investing also increases the odds of earning an attractive return on investment. Using another great analogy, Benjamin Graham likened stock markets in the short-term to a voting machine, driven by emotions and group-thinking. In the long-run, stock markets would behave more like a weighing scale, with stock prices eventually adjusting to the intrinsic value of companies.

Only well-prepared investors would be able to recognise and benefit from the opportunities offered by the short-term volatility in stock prices and subsequently hold their investments until the intrinsic values would eventually be reflected in market prices.

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