Chapter 20 of The Intelligent Investor: Margin of Safety

Ben Graham calls this chapter both “the secret of sound investment” and “the thread that runs through all the preceding discussion of investment policy”

We continue on today with the second of Warren Buffett’s two favorite chapters from The Intelligent Investor — Chapter 20: “Margin of Safety” as the Central Concept of Investing.

This is the final chapter of Benjamin Graham’s classic text — and you could certainly argue that he saved his best insights for last.

At its core, the “margin of safety” concept is all about risk management.

Which always makes me think about the episode of Seinfeld where George Costanza lies on his resume about being an expert in risk management and pretends to be blind in order to gain access to an audiobook on the subject before his secret is exposed.

The hapless George could have saved himself a lot of trouble by skipping the subterfuge and reading Chapter 20 of The Intelligent Investor instead.

Examining Chapters 8 and 20 in back-to-back weeks, it becomes clear that they are actually two sides of the same coin.

• Chapter 8 reminds us to go on offense during market fluctuations — pouncing on falling prices instead of cowering in fear or panic selling — while Chapter 20 teaches the importance of playing effective defense, too.

• Chapter 8 talks about remaining in control of our emotions during times of turbulence, while Chapter 20 demands a humble acknowledgement that there are many things in the money game that we cannot (and will never) control.

• Chapter 8 teaches us how to navigate the choppy seas of investing, while Chapter 20 makes sure that we won’t drown while out on the water.

Simply put, a margin of safety is the difference between a stock’s price (what you pay) and its intrinsic value (what you get). The lower the price you pay below that value, the bigger the margin of safety. This creates a buffer which safeguards the intelligent investor against the inevitable mistakes and misjudgments that we all make.

Ben Graham calls this both “the secret of sound investment” and “the thread that runs through all the preceding discussion of investment policy”.

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✨ “The margin of safety is always dependent on the price paid,” writes Graham. “It will be large at one price, small at some higher price, [and] non-existent at some still higher price.”

Investors get themselves into a heap of trouble when they forget (or refuse) to ask a couple of simple questions before making a purchase. Like, “How much am I paying for this?” And, “Is it really worth that price?”

The size of your margin of safety rests on the difference between the price you pay and the value you get. The bigger, the better.

Warren Buffett has echoed this point many times. “You do not cut it close,” he once warned. “That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds — but you only drive 10,000 pound trucks across it. That same principle works in investing.”

Or, to put it another way: Would it be smart to set out on a 200-mile roadtrip with 205 miles worth of gas in the tank? Probably not. Any unforeseen delay or hiccup in your travels would leave you stranded on the side of the road and your vacation in ruins.

When investors purchase stocks trading at a high price (compared to intrinsic value), they leave themselves virtually no margin of safety at all.

Instead, Graham beseeches us to remain grounded in the fundamentals of a particular business — and not to float away in a bubble built on hopes and dreams.

“The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions,” writes Graham. “The purchasers view the current good earnings as equivalent to ‘earning power’ and assume that prosperity is synonymous with safety.”

“Most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over — and often sooner than that. Nor can the investor count with confidence on an eventual recovery … for he has never had a real safety margin to tide him through adversity.”

And, while Graham was a dyed-in-the-wool value investor, this concept applies equally well to those of a “growth stock” persuasion. As long as the estimation of higher expected earnings “is conservatively made” and “shows a satisfactory margin in relation to the price paid”.

✨ Margin of safety is about how much of your money you will get back when you make a mistake. And, remember, you will make a mistake.

Perfection is not possible. Nowhere is that more true than in the money game. Each and every one of us must prepare for the inevitable missteps, misjudgments, and risks that lurk around the corner.

When you leave yourself with no margin of safety in purchasing a stock, it’s akin to setting sail without a lifejacket. Ideally, it won’t be needed — but it’s foolish to bank on fair weather and calm seas forever.

In the upcoming anniversary edition of The Intelligent Investor, editor Jason Zweig smartly dubs margin of safety as a “cushion of humility”.

Demanding a sizable margin of safety in every investment that you make is a humble acknowledgement that nobody is perfect, not everything works out just the way you expect it to, fluke events and circumstances are more common than people believe, and that you aren’t so foolish as to think that nothing can possibly go wrong.

When disaster strikes, a margin of safety allows the intelligent investor to live and fight another day.

In Warren Buffett’s example above, let’s say that $83 million business actually turned out to be worth only $60 million. Even the Oracle of Omaha makes mistakes when evaluating a company’s future prospects. If he had paid $80 million for it — leaving himself precious little margin of safety — Buffett would be staring down the barrel of a $20 million loss. Not good.

On the other hand, if Buffett demanded a big margin of safety and only bought it once the price dropped to $50 million, the investment would still be profitable even though he had badly misjudged the business’s intrinsic value.

Graham’s margin of safety reframes investment decisions from just thinking about being right all the time to humbly preparing for the worst. When an intelligent investor purchases a stock with a big margin of safety, he or she can easily (but not happily) absorb any risks that might lay in wait.

The foolish investors, meanwhile, YOLO their money into speculative ventures at nose-bleed prices — which end up knocking them right out of the game.

“People always want to believe that this time is different,” Seth Klarman told Harvard Business School magazine in 2008, “that there’s something new under the sun, and that through their own ingenuity they can wish away risk.”

Risk will always be there — and the best shield against that is the humble margin of safety. It’s not just a cushion, a buffer, or a safety net — it’s also your life-line.