The Margin of Safety in Financial Planning

“The intelligent investor must focus not just on getting the analysis right. You must also ensure against loss if your analysis turns out to be wrong – as even the best analyses will be at least some of the time. The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control. However, you do have control over the consequences of being wrong.” – Jason Zweig, Wall Street Journal columnist and author, Your Money and Your Brain.

Over the last several years, we are experiencing record foreclosures on homes across the country. One could argue (and very convincingly, I might add) that lenders should have never allowed people to obtain the mortgages they did leading up to this mess. However, home buyers are every bit as responsible for choosing to acquire a nearly fully leveraged asset (and more importantly, a liability) that provided no “margin of safety” in their financial life.

The conclusion these folks arrived at – that they could afford these homes (and second homes, and third homes) – was undeniably based on a wide range of assumptions. To name a few, these assumptions included (a) home prices will always increase, (b) tax rates will remain the same, (c) they will not lose their job or have to take a pay cut, and (d) that they will not experience any unexpected or “surprise” expenses like medical costs, home or car repairs, (e) cash flow will always be sufficient to meet obligations, etc. With no margin of safety in place to buffer against even one of these assumptions being incorrect, many people were caught sitting far out on an extended tree limb and had no chance of hanging on against the storm that quickly formed on the horizon.

With respect to its origins in investing, a basic description of the margin of safety principle is that it implies that there is a favorable difference between the price paid for an investment and its actual value – a buffer. So important is this concept, in fact, that virtually any time Warren Buffett is asked how investors can become better investors, he refers them to Chapter 20 in The Intelligent Investor (Benjamin Graham), aptly titled: “Margin of Safety” as the Central Concept of Investment.Margin_of_Safety

In a recent white paper, The Seven Immutable Laws of Investing, James Montier argues that “valuation is the closest thing to the law of gravity that we have in finance…the objective of investment (in general) is not to buy at a fair value, but to purchase with a margin of safety.” In other words, buying stock of a great company (or index) does not always mean it will be a great investment – the price you pay for it matters! The purchase of stock will be a great investment at one price, a satisfactory investment at another, and a bad investment at another.

For example, if you have done your homework and believe a share of stock is worth $30 and you pay $30 for it, you may, indeed, get a fair return. However, if your analysis and assumptions prove to be wrong and the stock turns out to be worth only $25, you have no buffer to insulate you against loss. Conversely, if you “always insist on a margin of safety” (Montier’s rule #1) and refuse to buy it for anything greater than, say, $20, you still yield a satisfactory (although less than expected) result. Of course, this is easier said than done.

In his book, Graham points out that the importance of the margin of safety has far less to do with maximizing return and far more to do with insulating oneself against the effects of a miscalculation, or more likely, incorrect assumptions. In the early 2000’s, people were buying tech companies – even the good ones – at impossibly high prices (no margin of safety), and the result was portfolio devastation.

This same principle holds true in financial planning.

Our investing and financial decisions are heavily based on the conscious and unconscious assumptions we have used to reach our conclusions. Let’s face it, whether you are forecasting the weather, speculating on the direction of the price of gold, or trying to predict who is going to win the NHL’s Stanley Cup this year, you must use a wide range of assumptions to draw your conclusion…and therein lies the problem with forecasting.

One of my favorite economists, John Kenneth Galbraith, said that “the only function of economic forecasting is to make astrology look respectable.” Our opinions are entirely based on the assumptions used and our often skewed biases, which exemplifies the necessity to create a buffer against ourselves.

To illustrate the sensitivity of assumptions in our financial lives, we are constantly making decisions today that have a far greater impact than most of us realize down the road. Unfortunately, we have no way of knowing the result of those decisions until 20 or 30 years down the road. Consider this: the difference between earning 8% per year on a $100,000 portfolio over 30 years and 6% on that same portfolio is a whopping $525,000! In percentage terms, that seemingly small 2% annual difference is a reduction in principal of 57% for the entire period!

Think about that for a moment – instinctively, we would immediately want to pin the blame solely on poor investment performance. But in reality, that difference may be the result of a wide variety things completely out of your control, such as a less favorable economic environment than the past 30 years, adverse changes to the tax code, a prolonged period of high inflation, currency debasement, wars, political revolution, and a variety of other things we can’t possibly foresee in the year 2011. Additionally, it may also be the result of things we can control, such as a miscalculation, buying and selling investments at the wrong time, or changing our savings and spending habits. A minor tweak to any of these variables can completely change the outcome of the model and result in the need for a permanent lifestyle adjustment.

These are all assumptions we make when determining insurance needs, what kind of car to buy, how much to gift to our children, what grad school to attend, etc.

“Always insist on a margin of safety.” This phrase is not meant to restrain you from living your life to the fullest today, but is meant to encourage you to be fully honest with yourself when assessing how much house you can really afford, how much you can afford to spend on a new car, and how secure you are in your current job. It is meant to encourage you to consider the possibility that your assumptions may be wrong, and more importantly, to realistically assess the risks to your financial life if that happens to be the case. It is much easier to adjust your lifestyle upward than it is to retreat to a lifestyle you have already moved forward from.

As true as it is when investing, it is far better to be approximately right than precisely wrong in your financial planning decisions as well.

* The phrase “margin of safety” was coined by Benjamin Graham and David Dodd in their 1934 book,Security Analysis, and further emphasized by Graham in his 1976 book, The Intelligent Investor(updated in 2003), which Warren Buffett has called “by far the best book on investing ever written.”