Investing can be a risky business, and it’s important to understand the concept of margin of safety. Margin of safety is the space between you and a potential negative event, and the greater your margin of safety, the safer you are. This concept is similar to the distance between your car and the car in front of you, known as the safe following distance.
Let say, if you are driving at a speed of 100 km/h on a highway, your safe following distance might be at least 100 meters. This distance takes into account the time it takes for your brain to detect danger, send signals to your feet to apply the brakes, and the braking distance of your vehicle. This already take 40 meters. Even if you have a good car, it will take about another 40 meters to stop, resulting in a total stopping distance of 80 meters.
It’s important to note that your actual margin of safety in this scenario is only 20 meters, not the 100 meters between your car and the car in front of you.
While the concept of margin of safety may seem conservative, it’s actually about taking calculated risks and seeking opportunities. In investing and business decision-making, it’s important to balance risk and reward while seeking opportunities with a reasonable margin of safety. By understanding the concept of margin of safety, investors can better navigate the ups and downs of the market and make more informed decisions.
The Importance of Margin of Safety in Business and Investment Decisions
When it comes to investment or business decisions, there is always a certain degree of uncertainty. Facing new opportunities, there are two typical mindsets: greed and fear. But neither of them is helpful in making the right decisions.
Read More
In any situation where one party has “high returns and low risk”, there must be another party that has “high risk and low returns”
Editor
To make the best decisions, you need to consider the margin of safety, which is the distance between you and the risk, representing your loss, but it won’t exceed that limit.
Firstly, you should act when you come across an opportunity. Excellent investment opportunities are always accompanied by long-term high premiums, and waiting too long may reduce the profit margin. But it doesn’t mean that the risk and return are always equal. There are times when the market presents a time window of high returns and low risk. Measuring this opportunity’s scale is the margin of safety.
Secondly, you need to judge the worst risk-reward ratio. The margin of safety represents your loss limit. For business decisions, the loss limit is the part of your resources that cannot be recovered, but for investment decisions, it’s the stock price corresponding to the company’s worst profit situation. The advantage of having a clear limit is that you can judge the worst-case scenario and decide the worst risk-reward ratio, which is essential in highly uncertain decisions.
For instance, most markets in the business world are highly competitive, and the opportunities for normal decisions are scarce. However, new business opportunities with margin of safety may arise when a market demand is growing and competitors haven’t responded yet, or when the industry is in a slump and the “survivors” can make a comeback.
To conclude, the margin of safety is a crucial factor in making business and investment decisions. It can help you judge the worst-case scenario and decide the worst risk-reward ratio, which is essential in highly uncertain decisions.
Two Types of Margin of Safety: Immoral and Ethical
Safety margin can be classified into two categories based on their sources:
Unethical safety margin refers to the asymmetrical risk taken by your subordinates, colleagues, relatives, clients, business partners, investors, and other stakeholders who trust you. CEOs who frequently make high-risk decisions of this nature often end up fail and lost.
Kind-hearted safety margin, on the other hand, comes from the mistakes of your competitors, mis-pricings of counterparties. This is the type of safety margin that is worth pursuing and can provide a long-term advantage.
True safety margin comes from “asymmetrical risk.” In any situation where one party has “high returns and low risk,” there must be another party that has “high risk and low returns.”
CEOs are decision-makers in business, but any decision involves multiple stakeholders such as shareholders, employees, and suppliers who bear most of the risk. If the CEO fails to make an arrangement to compensate for their risks, this is another form of “asymmetrical risk.”
The same is true in investment, where many fund managers prefer a high-volatility investment style on a single track because the higher the volatility, the more beneficial it is to the fund manager. It attracts investors’ attention quickly when it soars, and the risk of the dramatic fall is mainly borne by the investors.