Wednesday, May 24, 2006

Margin of Safety

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 chio babe 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 she might bring two of her chio friends and you are in deep shit 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.
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