Margin of Safety

By Ben Dolan, CFP®

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In 2010, at the annual shareholder meeting of Berkshire Hathaway in Omaha, NE, a guest asked Warren Buffet and Charlie Munger an important question about the nature of investing (I’m summarizing): how much opportunity did I miss out on during the market decline of 2008/2009 when I was too scared to buy stocks because I was worried about a global economic crisis?

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This is an excellent question because it lays bare the risk/reward dilemma all investors face but adds the element of economic crises into the scenario. But, when hearing a question like this, which is focused on turmoil at hand, I often wonder if the investor has not done a good job defining for themselves a critical investment concept: margin of safety.

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My firm defines margin of safety as follows:

• keeping debt at a manageable level; 
• diversifying rather than betting heavily on one investment; 
• having enough income/assets/cash reserves that you don't need the market to cooperate at a particular time.

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Buffet and Munger, longtime advocates of margin of safety, answer the investors question differently.

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Buffet responds that the decision to invest or not invest is a matter of temperament: “if, when others are fearful you are going to be scared yourself, you’re not going to make a lot of money in securities over time.” Warren is referring not only to investing during crises, but at all times, since, on any particular day in the market, you’ll find a neighbor or in-law or investment professional or media outlet that tells you the next boom or bust is right around the corner and what you should do about it (i.e. go short, go long, lever up, go to cash, etc., etc.). 

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Munger answers the question thus: “I think I developed more courage after I learned I could handle hardship. So, maybe you should get your feet wet with a little more failure.” I like this answer. It rings true to me both in and out of the investment world. Take an appropriate amount risk. Even if you fail, you will learn something valuable which will help your character develop.

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Both answers are excellent, and when combined with a margin of safety, can do wonders for long-term investors.

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Jason Zweig, in his commentary on Chapter 20 of Benjamin Graham’s classic, The Intelligent Investor, provides a few key points on the concept of margin of safety:

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• The people who take the biggest gambles and make the biggest gains in a bull market are almost always the ones who get hurt the worst in the bear market that inevitably follows (pg 525).

• Losing some money is an inevitable part of investing, and there’s nothing you can do to prevent it. But, to be an intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money (pg 525).

• Before you invest, you must ensure that you have realistically assessed your probability of being right and how you will react to the consequences of being wrong (pg 529).

• Simply by keeping your holdings permanently diversified, and refusing to fling money at Mr. Market’s latest, craziest fashions, you can ensure that the consequences of your mistakes will never be catastrophic. No matter what Mr. Market throws at you, you will always be able to say, with quiet confidence, “This, too, shall pass away.” (pg 531).

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With the right temperament, with courage, and with a margin of safety, investors can let the 8^th wonder of the world, compound interest, run wild!