Overview – Having Enough Room to Work With
No matter how experienced, skilled, or talented someone is, there’s always the possibility of making a mistake or miscalculation. After all, nobody is perfect, so the occasional mistake or miscalculation here and there is to be expected. To make matters worse, there are certain external variables which we cannot possibly control yet still impact our work.
Because of our innate imperfections and the whims of uncontrollable variables, trying to perform every task we do perfectly is impossible. In addition, the more complex a certain task is, the higher the probability of errors being made along the way. What, then, can we hope to do?
Most people recognize the futility of trying to achieve perfection in their work, so instead, they anticipate these imperfections and give themselves a range of acceptable results/outcomes; that is, they give themselves a bit of room to be wrong. This same idea can also be applied to investing.
No investor is perfect, and investors live and work in an imperfect world, but that doesn’t mean investors are powerless. By giving themselves a sufficient margin of safety, investors can carry out their work even if imperfections and other errors are present.
The Origin of “Margin of Safety”
The concept of Margin of Safety is something that’s closely linked with value investing, specifically when calculating intrinsic value, so let’s review what it is before going a bit more in-depth about the margin of safety.
Intrinsic value is what an investor believes is, based on their analysis, the “true” price of a given investment instrument. This value can either be above or below the investment’s prevailing market price – it all depends on how investors choose to perform their valuation calculations.
Because intrinsic value can be calculated in various ways, different values can be calculated, but nobody knows for sure what the “correct” value is.
This leads us to the problem inherent in calculating intrinsic value: because the “correct” intrinsic value is impossible to precisely pinpoint, the values that investors calculate can be very close to this correct figure, or they can be significantly off the mark, yet nobody can definitively say that their intrinsic value is the correct one.
What, then, can investors do to deal with this risk?
This is where the idea of having a margin of safety comes into play.
Rather than trying to find a precise number, investors can instead calculate a range of what they believe are acceptable intrinsic values. By doing this, investors grant themselves more flexibility with their decisions even in the absence of a precise value.
For example, imagine that an investor calculates the intrinsic value range of a given stock to be $45 – $65. They don’t know what the precise intrinsic value is, but as long as they decide to buy/sell in this range, then they can act with reasonable confidence that they aren’t too far from the “true” value without running the risk of grossly overpaying or underselling.
Approximating the intrinsic value to a specific range is far more practical and less time-consuming than trying to find a precise value that may or may not be correct.
While the concept of margin of safety is a key element of value investing, the underlying idea of being able to make decisions even if investors are a bit off the mark isn’t limited to just finding intrinsic value. Applying a margin of safety can be applied to various aspects of investing – the only real limit, if there is one, is an investor’s creativity.
A Margin of Safety Allows Us to Work in Imperfect Circumstances
If it had to be described another way, having a margin of safety is more or less the idea of “it’s better to be approximately right than to be precisely wrong.”
Now, this doesn’t mean having a margin of safety permits investors to be sloppy with their work. Rather, it’s a way of working with the reality that errors and imperfections, both inherent and external, will always be present, but can allow the work we do to still proceed with reasonable confidence despite these.
In science and engineering, any sort of value that’s obtained through measurement is assigned a margin of error, usually expressed as “+/-“. This is because even the most high-quality measuring tools are still imperfect, and not all circumstances allow for ideal data collection.
However, as long as the values fall within an acceptable margin of error, then there usually aren’t any problems. Even the world’s most impressive scientific and engineering feats had errors and imperfections present in their construction.
In most cases, being approximately right is more practical and cost-effective than trying to get the “perfect” value. Even if the “perfect” values were to be calculated, the gains they offer are usually marginal at best.
Investors live and work in an imperfect world, but being perfect isn’t required to advance their work or achieve their goals. As long as investors operate within their margins of safety, then they can confidently make decisions even in the face of potential errors and imperfections.
What’s Considered an Acceptable Margin of Safety?
Having a margin of safety is great, but how will investors know if the margin they’ve established is sufficient? A margin of safety that’s too narrow offers minimal flexibility, while one that’s too broad can increase the potential error beyond what’s tolerable.
Knowing whether a given margin of safety is sufficient will depend on several variables such as the task at hand (e.g., valuing an investment vs. trying to implement an investment strategy), an investor’s knowledge/experience, and an investor’s error tolerance, to name a few. Additionally, margins of safety aren’t set in stone and can be adjusted at any time, such as when new information is made known or if circumstances change.
Frustratingly, there are no objective measures of when a margin of safety is sufficient – it varies on a case-by-case basis and between individual investors.
Earlier, we reviewed an example whereby an intrinsic value range for a given stock was $45 – $65. An experienced investor who’s valued similar stocks before may find this range acceptable, and may even be willing to narrow it. Conversely, an inexperienced investor who has performed only a few intrinsic value calculations may want to extend this range just to be sure.
Regardless of how investors choose to establish a margin of safety for a given investment task, it’s important to remember what its underlying purpose is: to help them carry out their work even with the inevitable presence of errors and imperfections.
Different Aspects of Investing Where a Margin of Safety Can Be Applied
Theoretically, there are no limits as to when or how investors decide to implement margins of safety in their work, but what exactly are some specific applications? To help generate some inspiration, we will go over a few examples.
Valuations
Earlier we discussed how the concept of margin of safety is closely tied to value investing, specifically when it comes to finding intrinsic value. However, a margin of safety is applicable regardless of what valuation techniques or methodologies an investor decides to use.
Whether an investor chooses to follow a relatively simple valuation method or decides to use advanced math to do so, it doesn’t hurt to try and calculate a range of acceptable values instead of spending excessive time and energy finding the “perfect” value which could only lead to marginal gains.
Investment Analysis
When it comes to investment analysis and having a margin of safety, we won’t focus on the act of analysis itself but rather on the time investors spend performing said analysis.
No matter how experienced or knowledgeable an investor may be, performing investment analysis takes a fair bit of time, effort, and energy. Because of this, it’s important to allocate enough time for this task. However, circumstances can change, which can throw this original time allotment off, potentially jeopardizing an investor’s scheduling. After all, time is money.
To help prevent this, investors may want to give themselves a bit more time than they originally anticipated so that even if unexpected circumstances arise, their schedules won’t be dramatically thrown off.
Investment Strategies
Investors deploy all kinds of strategies to help them achieve their goals, ranging from very simple to highly complex. Regardless of what kinds of strategies deploy, there’s always the possibility of them being thrown off track.
Now, we’ve previously discussed the importance of adapting to unforeseen circumstances and having backup investment strategies, and while these things are certainly important, it doesn’t hurt for an investor’s strategies to account for possible imperfections every now and then which don’t require a major pivot or change in strategy.
Instead of being too rigid with expected results or timelines, investors can give their strategies a bit more wiggle room before deciding to adapt or change them entirely. A strategy that seeks to grow a portfolio by 15% over the next few years is ambitious, but there’s no harm in extending that range to, say, 12%-15% growth to account for potential extraneous circumstances.
Wrapping Up
No matter how skilled, experienced, or meticulous an investor is with their work, there will always be errors and imperfections present. Sometimes these errors are ones they made themselves, while other times they’re inherent to the work being done.
Fortunately, there’s a simple yet effective tool that can help investors confidently perform their work: margins of safety.
A margin of safety is a way of ensuring that, even if investors find themselves off the mark due to errors or imperfections, then the work they do won’t be greatly impacted. This is applicable when trying to value an investment or when deciding how much time is needed to perform investment analysis.
Regardless of how investors choose to apply it, the underlying idea behind a margin of safety is simple: it’s better to be approximately right than be precisely wrong.
