Wednesday, May 24, 2006

Margin of Safety

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.