What is margin of safety and why do you need it?

When a ship sets sail, it carries lifeboats for all passengers and crew, even though the plan is for everyone to remain safely on board. These lifeboats serve as a safety net in case of dire circumstances like severe storms or capsizing of the ship.

Similarly, a volatile and unpredictable affair like stock market investing also needs a lifeboat. Such a safety net in market investing is the margin of safety.

What it means

Ensuring a margin of safety means purchasing stocks at prices well below what they are worth i.e., their intrinsic value. By doing this, investors essentially shield themselves against any financial storms that may get triggered by market downturns. Taking into account possibilities of unforeseen events protects your investment, ensuring it stays afloat even if the market or a company's earnings decline. Just as lifeboats provide peace of mind on a ship's journey, the margin of safety offers confidence and protection in your investing journey.

Why do you need it?

All of us make mistakes. In fact, when it comes to investing, time and again, we have seen that investors are susceptible to the market's follies. Investors are prone to many psychological biases and tend to become their own worst enemies.

This is where the concept of margin of safety helps us. Specifically, it helps in two ways:

By protecting you against overpayment

The stock market is inherently volatile. Prices can fluctuate widely based on various factors, including business performance, economic data, and investor sentiment. By ensuring that you buy a stock for less than what it's worth, you build yourself a margin of safety. This provides you a cushion that can help offset any potential downturns in the business or stock's performance.

By mitigating forecasting errors

You invest in a stock to enjoy returns in the future. However, predicting how a business will grow over the next five or ten years with accuracy is close to impossible. Therefore, maintaining a margin of safety reduces your reliance on precise predictions, and increases the odds that your investment will yield satisfactory results even if actual outcomes differ from expectations.

Also read: What is value investing?

Here is an example highlighting the importance of the margin of safety.

As the exclusive licensee of the JOCKEY brand in India, Page Industries is the market leader in the men's innerwear segment. As the business prospered, the stock multiplied by five times in the five years ending August 27, 2019. On this day, the company's price-to-earnings ratio (P/E) was 102 times. Fast forward another five years and the stock has barely moved, generating only 1.1 times return as of June 28, 2024. The P/E has come down to about 78 times. It appears that the stock has reacted to the slowing business growth and the rise of new entrants in the industry.

The company continues to be healthy with enviable margins. However, if you had invested in the company 10 years ago without accounting for possible adversities in the business i.e., without maintaining a margin of safety, you are likely worried sick now. Most likely, you have already sold the stock. That brings us to an important lesson.

Your takeaway

The danger lies in the market's tendency to price stocks at levels that do not adequately factor in a conservative projection of future earnings. And that's why a margin of safety is always dependent on the price you pay for a share. In the words of Benjamin Graham, " the margin of safety will be large at one price, small at some higher price, nonexistent at some still higher price ."

So, always be on the lookout for a margin of safety when investing. You increase your odds of success by investing in a diversified portfolio of stocks with a margin of safety.

Also read: Must-follow investment principles for smart investors