Every investment and every trade rests on assumptions that might be wrong. The margin of safety is a simple idea for dealing with that uncomfortable fact: leave room for error. It was made famous by Benjamin Graham, the investor who taught Warren Buffett, and it is just as useful for a short-term trader as for a long-term investor.
What margin of safety means
In investing, the margin of safety is the gap between what you think something is worth and the price you pay for it. If you believe a share is worth £10 and you buy it at £7, you have a margin of safety of £3, or 30 per cent. Even if your estimate of value turns out to be too optimistic, you have some protection.
Graham compared it to building a bridge. An engineer designing a bridge to carry 10 tonnes would build it to carry much more, because nobody can be certain of every load it will face.
Why it matters
Valuations are estimates, not facts. Forecasts for profits, interest rates and growth are frequently wrong. A margin of safety means you do not need everything to go right to avoid losing money. It also makes it easier to hold your nerve when prices fall, because you bought with a cushion in place.
The idea also cuts the other way. Paying a very high price for a popular company leaves no margin of safety. If growth slows even slightly, the share price can fall a long way, as investors in expensive technology shares are regularly reminded.
How traders apply the idea
Short-term traders rarely calculate the long-term value of a company, but they use the same thinking in risk management. They size positions so that a single loss does not do serious damage. They place stop-losses at levels that allow for normal market noise. They avoid trades where the potential reward is barely larger than the risk. Each of these leaves room for being wrong.
A simple example
Suppose you estimate a share is worth 500 pence. One trader buys at 490 pence, believing the estimate is accurate. Another waits and buys at 400 pence. If the true value turns out to be only 450 pence, the first trader is losing money while the second is still comfortably ahead. The second trader’s estimate was just as wrong, but the margin of safety absorbed the mistake.
Common mistakes
A common mistake is assuming a share that has fallen a long way must have a margin of safety. If the business is deteriorating, its value may be falling faster than the price. Another is being so demanding that you never act. A third is calculating a margin of safety from an over-optimistic valuation in the first place.
The bottom line
Margin of safety means leaving a cushion between your estimate of value and the price you pay, so that mistakes do not become disasters. Investors apply it to valuation, and traders apply it through position sizing, stops and sensible risk-reward. For a related tool, read our guide to the risk-reward ratio. If you want to see how much room for error your own approach leaves, try the free Samuel & Co Trading Trader Assessment.
