Ben Graham called margin of safety “the secret of sound investment” and “the central concept of investment”. He also devoted a whole chapter to the concept and, I am confident, placed it last because it is the most important.
Margin of safety is, as he put it, “the thread that runs through all the preceding discussion of investment policy”. They are the 3 most important words in The Intelligent Investor.
This is Part 8 of our book review of The Intelligent Investor, Revised Edition, Updated with New Commentary by Jason Zweig (affiliate link). Part 8 covers Chapter 20 – Margin of Safety as the Central Concept of Investment.
You may find the Introduction and relevant links at: The Intelligent Investor Book Review in 30 Minutes.
Exponentially Higher Returns
The margin of safety for an investment is the difference between the real or fundamental value and the price you pay. The goal of the value investor is pay less (hopefully, much less) than the real value.
The greater the margin the more leeway you have for negative conditions before you lose money. On the other hand, if conditions are as you expected or better, profits are exponentially higher the greater the original margin.
Here is an example of exponentially higher returns. You have estimated the fundamental value of a stock to be $50 and you purchase it with a 20% margin of safety ($40). If your stock reaches your fundamental value you have a 25% return ($50 divided by $40). However if you purchased the stock with a 50% margin ($25), you have a 100% profit ($50 divided by $25).
Function of Margin of Safety
Almost anyone, with a little knowledge and hard work, can analyze the past. Mr. Graham demonstrates the importance of this exercise throughout The Intelligent Investor. However, even the best analysts are unable to consistently and accurately forecast the future.
The function of having a margin of safety is to make accurate forecasts of the future unnecessary. In other words, having a safety buffer allows for inaccurate forecasts. It gives you leeway for conditions that are less than optimum because that is usually what happens.
The Price Paid
The amount of safety is completely contingent upon the price paid. Every investment (there are few exceptions) has a price where the margin of safety would be sufficient for purchase. Determining what your purchase price is, and having the discipline to only buy at or below that price, is where the difficulty rests.
There is risk in paying too high a price for a good quality investment. However, Graham noted that investors suffer more often from buying low quality investments during times of economic stability and growth.