This post is updated in 2023.
The margin of safety (coined by Benjamin Graham, father of value investing) is a concept of buying investments that are significantly cheaper than its intrinsic value. The key word here is "significant". We need to buy with a margin of safety to minimize the risk of losing any money.
Let's put it this way, imagine that you are going out on a date with a babe (or a dude) and you think you will need S$100 for that night. Will you bring $105 or will you bring $300? That is the meaning of margin of safety.
*For those still blur, the answer is S$300 because what if the chef of the posh restaurant you booked fell sick and they closed for the day and you have to go the next restaurant charging $100 per pax. So, you will be in deep sh*t if you only have S$105 in your pocket.*
Going back to my favourite analogy, let's assume that our friend bought the golden tap to re-sell it to another buyer. According to his calculations (see previous entry), which was the same as ours, the golden tap is worth $1060, and he bought it for $1000. So he could have sold the tap to another buyer who is willing to pay $1060 and he earns $60.
However as you can see, this trade does not have a margin of safety. What if the tap can only sell for $900 because our assumptions were wrong? What if gold dropped 10% the next day? If he bought the tap for $500, then the trade would have earned the praise of the guru himself, by having a good margin of safety.
See also Definition: Value investing
and Intrinsic value
Assuming that we can work out the intrinsic value correctly. We still will not be able to forecast with certainity future cost (eg your eg about gold declining by 10% overnight). So wouldn't the Margin of safety a moving target? Is there any industry benchmark? for various sector? Is this a `feeling' thing again?
ReplyDeleteI tend to see intrinsic value as the moving target and margin of safety should be say 40-50% of that. Say if you calculate that the intrinsic value of the stock is $100, then you should buy it only if it is trading at $60 today.
ReplyDeleteSo if I am wrong and the intrinsic value is actually only $50. Theoretically, I will only lose $10.
Heyy, just some trivia regarding the concept of margin of safety.
ReplyDeleteAlthough Warren Buffett is often associated with this term, its true origin is from the Sage of Omaha's intellectual predecessor, Benjamin Graham, who first co-wrote about it in "Security Analysis", and then emphasised it in his concluding chapter in "The Intelligent Investor".
For Benjamin Graham, margin of safety usually meant a low PBR and PER for stocks, and a low Net debt-to-equity for bonds.