Why the “margin of safety” theory could be a valuable part of your financial plan
Posted onA “margin of safety” gives you a cushion to allow for losses or inaccurate assumptions in your financial plan. It could mean your goals remain on track, even if things don’t go exactly as you expect. Read on to find out why it could be a valuable part of your plan.
The margin of safety was popularised by the “father of investing”
British-born American economist and investor Benjamin Graham is often referred to as the “father of investing” after he wrote two founding texts about investing in the 1930s and 1940s. His approach to investment philosophy often focused on investor psychology, such as how emotional and cognitive factors affected the decisions investors made.
His theories earned him many disciples in the investing world, including famous investor Warren Buffett, who, according to Forbes, is the fifth richest man in the world with an estimated fortune of $106 billion (£83.9 billion).
The margin of safety is one of Graham’s key principles, so what does it mean?
In simple terms, it’s the difference between the intrinsic value of a stock and its market price. The idea is that you should only buy stock when it’s worth more than its price on the market. It aims to protect investors from downturns in the market and their poor decisions, which may be influenced by emotions or bias.
While Graham linked the principle to investing, it’s used in other industries too. For instance, engineers will often have a large margin of safety to account for potential mistakes.
Buffett once explained the idea by saying: “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.”
Through the margin of safety, Graham sought to take an investment approach that focused on assessing risks before looking at potential returns. So, rather than asking “How much could the price of the share increase by?” you seek to understand “Could the value of the share fall?” first.
The margin of safety allows for some investment losses
The key benefit of the margin of safety is that it allows for some losses to occur without having a huge negative effect on your portfolio.
It could also help offset some forms of bias. For instance, overconfident investors might lead to a stock price that is higher than the intrinsic value.
The margin of safety doesn’t guarantee a successful investment. Determining intrinsic value can be difficult and investment values can be volatile and unpredictable. Even Graham got it wrong at times. Indeed, his margin of safety principle came after he lost most of his money, like many other investors, during the stock market crash of 1929 and the subsequent Great Depression.
Remember, all investments carry some risk, and you should understand what level of risk is appropriate for you.
The margin of safety could be applied to other areas of financial planning too
The idea of creating a cushion to account for mistakes or provide you with a buffer in case the unexpected happens isn’t only useful when you’re investing.
Think about when you’re creating a household budget. You might round up certain repayments, like your utilities, in case your bill is higher than anticipated. Or you may ensure you have money that’s not allocated to anything specific to cover the unexpected.
A margin of safety could be useful when you’re making long-term plans too.
Let’s say you’re a woman retiring at age 60. The Office for National Statistics estimate that, on average, you’d spend 27 years in retirement. But if you divided your pension up into 27 segments to create an income, what would happen if you were one of the 1 in 4 women who live to be 94? You could face financial hardship in your later years.
You might also plan for the cost of living to rise by 2% a year throughout retirement and reflect this in the income you take – 2% is the Bank of England’s inflation target after all. However, as the last two years have demonstrated, inflation can rise significantly above that target.
So, while we make assumptions when creating a financial plan, a margin of safety might provide you with security even if things don’t go exactly as you expect.
Contact us to talk about your financial plan
If you’d like to discuss how we could work with you to create a financial plan that considers your long-term financial security, even when the unexpected happens, please get in touch.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.
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