The 3 Most Important Words in Investing
The Oracle of Omaha, billionaire investor Warren Buffett, once quipped that “margin of safety” may be the three most important words there is when it comes to investing.
Buffett’s mentor, Benjamin Graham, wrote in the very last chapter of his book, The Intelligent Investor, that the margin of safety is the central concept in investing.
So what exactly is this margin of safety? It is simply the difference between the price of a business and its intrinsic value. The lower a business’s intrinsic value is compared to its stock price, the larger the margin of safety. When investing, investors should know the value of a particular asset and then pay way less than the value in order to have a margin of safety.
For example, if you had determined the intrinsic value of Company X to be $10 per share and it is currently trading at $5, you have a margin of safety of 50%. Graham wrote in The Intelligent Investor:
“The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.”
Margin of safety is essential as it gives investors room for error, such as overlooking a certain aspect of the business while analysing it. No one can analyse a company perfectly. Pat Dorsey, an investor and the author of the book, The Five Rules for Successful Stock Investing, once said:
“Having a margin of safety is critical to being a disciplined investor because it acknowledges that as humans, we’re flawed”.
Furthermore, if an investor had bought a stock with a margin of safety in place, he or she would have already “made profits” as the shares were bought at a discount to its business value. By purchasing a share worth S$6 for S$4.50, the investor has essentially “made” S$1.50 immediately.
Buffett summed it up when he compared the margin of safety to driving across a bridge in his classic investing essay, The Superinvestors of Graham and Doddsville:
“You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close.
That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.”