The stock market presents you with methods to make money. For instance, you could keep it simple and invest in stocks, or you could gain experience and begin futures trading. Regardless of how you grow your wealth, it is impossible to attain a 100% success rate. Only some of your investments will become multibaggers. Similarly, not every trade will end up being a profitable one.Bad investments and losses are part and parcel of stock market investing. So, in the end, finding success in the stock market comes down to managing risk efficiently.
Margin of safety
The “margin of safety” is one of the most popular phrases in the stock market and financial world associated with risk management. The world-renowned investor Benjamin Graham introduced the concept of margin of safety in his book “The Intelligent Investor”, published in 1949. Ever since then, investors across the globe have put the principle into practice. Successful investors like Warren Buffet only purchase securities if they see a certain margin of safety.
The principle states that before making investments, investors must analyse the value of the assets at their current market price. Then, they go ahead and invest only if they conclude that there is a significant margin of safety in its valuations. As per Benjamin Graham, there is a margin of safety if the difference between the current market price and the intrinsic value of a company’s stock is significant. The intrinsic value of a stock is calculated by estimating the current value of its future cash flows. However, the intrinsic value is also an educated guess. So to put it plain and simple, if you conclude that a company share is trading at a significant discount to its actual value per your analysis, there is a certain margin of safety in making that investment.
For example, suppose you conduct a thorough fundamental analysis of a company with a share price of $1,700.However, based on your analysis, you estimate the company’s true value to be $2,000In this case, your margin of safety is 300, which is 15% in terms of percentage. Likewise, another way to assess the margin of safety is by evaluating the company’s price-to-earnings ratio (PE ratio). For example, suppose you find a company trading at a PE ratio of 20. However, as per your analysis, the stock should be trading around a PE ratio of 30. In this case, the margin of safety is more than 30%.
The importance of the margin of safety
So when there is a margin of safety, the downsides will not be significant in the scenario where your investment thesis goes wrong. So, it provides you with a cushion or comfort level when you make a purchase and helps limit losses. However, the margin of safety one would look for would depend on the investor’s perception of risk. For example, value investors prefer a margin of safety of 30% or more. In contrast, an investor with a higher appetite for risk would be pleased with a 20% margin of safety.
Macroeconomic factors like inflation and rate hikes can severely impact markets and lead to market corrections. However, suppose you invested in an overvalued company before those unanticipated factors influenced the market. In that case, the overvalued company’s share price will show a sharp correction. In comparison, if you had invested in a company where the margin of safety was high, the market correction would likely not result in a drastic fall in the stock price.
However, what can traders learn from the concept of a margin of safety? If you are into intraday futures trading, the entry into the trade is not based on the valuation of the underlying asset. However, in this case, you can limit your downside by placing an appropriate stop-loss. So a trading strategy with proper implementation of a stop-loss is more or less the equivalent of a margin of safety if you are a trader in stock, options, or futures trading, as it lets you decide the capital you are willing to risk.
As investors, we can study a company’s valuation based on past trends and assumptions about its future growth triggers. However, after all, valuations are only estimates, and there is no certainty that they may trade at the expected valuation after a specific period. At the same time, investors can never gauge the magnitude of factors like inflation, changes in industry trends, and rate hikes. Hence, the margin of safety is like protection against the unknown. You can effectively manage risk by applying the principle of safety or margin before making an investment decision. Reducing the downside of your investments will make you more successful in the stock market.