Dubai: When it comes to matters of money, it’s most often in our nature to be conservative and set aside a portion of our hard-earned money for any ‘what if’ scenarios that turn into actualities.
To know whether or not you do, just answer Yes/No to these five simple questions:
• Do you own an insurance policy?
• Do you save money?
• Do you keep extra cash (more than you will need) with you when you travel?
• Do you believe that precaution is better than risk when it comes to investments?
If you answer ‘Yes’ to all or most of the above questions, you are a practitioner of ‘margin of safety’.
When 1,000-plus people were surveyed worldwide to determine whether they have a substantial financial buffer to navigate unexpected costs, three global surveys indicated that roughly eight in 10 people have savings’ buffers.
Do you often find yourself setting aside a money buffer?
Long-time UAE resident Fahed Abbas, who was born and brought up in Abu Dhabi, agreed that he too, like many of his colleagues, has a habit of always leaving extra financial room when saving, spending and investing.
“Like many others, it’s a natural tendency for myself and my friends to save for a rainy day, but I personally keep my spending limit at 60 per cent of income (which includes all of my monthly expenses and loans), investing about 20 per cent and leaving the rest for any ‘what if’ scenarios,” Abbas said.
This is an example of what is known as ‘margin of safety’, and a typical scenario of how many of us naturally keep some extra money in hand, in case things do not go as planned – like if you run out of cash during your travel, or find yourself in a tight spot financially when a crisis strikes.
It’s a natural tendency for myself and my friends to save for a rainy day, but I keep my spending limit at 60 per cent of income, investing about 20 per cent and leaving the rest for any ‘what if’ scenarios
The same ‘margin of safety’ concept applies to investing too
The same ‘margin of safety’ applies even to stock market investing. In fact, these are often considered highly integral when investing your savings in a volatile market.
“A high safety margin is preferred, as it indicates a wide buffer to absorb any unforeseen uncertainty or volatility. On the other hand, a low safety margin indicates a not-so-good position,” explains veteran Saudi Arabia-based stock market investor Hamid Ghadi.
In simple terms, for stocks, a margin of safety is the difference between the inherent value of a stock and its market price.
This principle suggests that you must buy a stock only when it is worth more than its price in the market.
‘Margin of Safety’: Insurance when investing
Here’s an example. Let’s say a stock is trading at Dh100 in the market, and you calculate the company’s intrinsic value as Dh150 (based on the stock’s earnings and growth potential, as calculated by analysts).
This way you have a ‘margin of safety’ of Dh50 (150 minus 100). In other terms, the stock is trading at a 33 per cent discount to the company’s intrinsic or inherent value.
“If the said stock is of a high quality company, it is recommended that you buy it at any price that is 80 per cent or lower than the company’s intrinsic value (any price lower than Dh120),” noted Ghadi.
“If the above stock is of a firm that is not an exceptional one (but worthy enough for investment), you must not buy it for more than 50 per cent of the intrinsic value (only if the price is lower than Dh75).”
How does keeping a ‘margin of safety’ help?
When speaking to Ghadi, he evaluated how a ‘margin of safety’ is what protects you from poor decisions and downturns in the market.
“If you pay just Dh100 for a stock that you believe is worth Dh150, even if your analysis goes wrong and the stock is actually worth less than Dh150, your investment will still be safe,” Ghadi further noted.
“Given that the calculation of intrinsic value (of Dh150 in this example) is subjective in nature, it is always better to have a good ‘margin of safety’ while buying a stock.”
A 30 per cent to 40 per cent ‘margin of safety’ is what Graham recommends. This disciplined pursuit of bargains (stocks available for 30 per cent to 40 per cent less than their intrinsic values) makes value investing very much a risk-averse approach.
However, experts reiterate that the greatest challenge for you as an investor is to maintain that required discipline.
If you pay just Dh100 for a stock that you believe is worth Dh150, even if your analysis goes wrong and the stock is actually worth less than Dh150, your investment will still be safe
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As investors, data shows that many fall in the trap of following the herd, often referred to as ‘herd mentality’ among investors.
“We, as investors, buy stocks when the prices are rising, just because we do not want to miss out on the paper profits that our friends, colleagues, or relatives are making by betting on rising stocks,” shared Aditya Srivatsav, an India-based stock market investor.
“But then, being a value investor means standing apart from the crowd, and challenging conventional wisdom. It can be seem very isolated being a value investor practising a concept like ‘margin of safety’.”
However, experts remind that if you can do it with utmost discipline, you can earn great returns from the stock markets over the long run.
How much margin is good ‘margin of safety’?
When delving into what is an adequate margin of safety, the answer varies from one investor to the next. But it chiefly depends on –
• How much setbacks are you willing and able to tolerate?
• How much volatility in business values can you absorb?
• What is your tolerance for error and risk?
“In short, it all boils down to how much you can afford to lose. Losing some money is an inevitable part of investing. In fact, there is nothing you can do to prevent it,” Ghadi added.
“But to be a sensible and intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money.”
Key takeaways
Using the ‘margin of safety’ concept, and by refusing to pay too much for an investment, you minimise the chances that your wealth will ever disappear or suddenly be destroyed.
By purchasing stocks at prices well below their target, this discounted price builds in a margin of safety in case estimates were incorrect or biased.
An intelligent investor must focus not just on getting the analysis right. He must also insure against loss if his analysis turns out to be wrong – as even the best analyses will be at least some of the time.
In accounting the safety margin is built into break-even forecasts to allow for some leeway in those estimates.
Because investors may set a margin of safety in accordance with their own risk preferences, buying securities when this difference is present allows an investment to be made with minimal downside risk.
