Words Of Wisdom
“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety”
- Benjamin Graham
BY RADHIKA SETHI | 2
Mins Read
The margin of safety principle was popularised by famous
British-born American investor Benjamin Graham, also known as the father of
value investing and his followers, most notably Warren Buffett.
The principle of Margin of Safety refers to one in which an
investor only purchases securities when their market price is significantly
below their intrinsic value. The difference between the market price and the
intrinsic value is referred to as Margin Of Safety. For an investment with less
risk, it is advisable to buy this security when this difference is present.
For example, if one was to determine that the intrinsic
value of ABC stock is Rs 1620, which is well below its share price of RS1920,
he might apply a discount of 20% for a target purchase price of Rs1300. In this
example, he may feel ABC has a fair value at Rs1920 but he would not consider
buying it above its intrinsic value of Rs1620. In order to absolutely limit his
downside risk, he sets his purchase price at Rs1300. Using this model, he might
not be able to purchase ABC stock anytime in the upcoming future. However, if
the stock price does decline to Rs1300 for reasons other than a collapse of
ABC’s earnings outlook, one could buy it with confidence.
Warren Buffett describes margin of safety concept using this
example – “When you build a bridge, you insist it can carry 30,000 pounds, but
you only drive a 10,000 pound trucks across it. And that same principle works
in investing.”
Like we should have a margin of safety in life as a backing to whatever we plan on doing, it is imperative to have a margin of safety in one's Investments as well. This principle can also be linked to the quote "Precaution is better than cure" since it is always better to be prepared in advance as to what the outcome will be before investing in it. Therefore, margin of safety is an extremely helpful and important concept in the financial as well as the non financial world.