In investment, having a margin of safety itself is not sufficient. Why is this so?
Benjamin Graham, the founder of value investing, uses the simple basis of the insurance-underwriting business to explain the need for diversification. He said that diversification is the companion of margin of safety. In other words, margin of safety and diversification go side by side.
Benjamin Graham put it this way: “Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.”
The founder of value investor added that diversification is an established tenet of conservative investment.
Benjamin Graham uses the arithmetic of American roulette to explain when diversification is foolish. In American roulette, most wheels use “0” and “00” along with numbers “1” through “36”. There are therefore 38 slots. A person betting $1 on a single number will be paid $35 when he wins but the chances are 37 to one that he will lose. The player thus has a “negative margin of safety”. The more number he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel. Diversification in this case is therefore foolish. Suppose the winner received $39 profit instead of $35. In this case, he would have a small but important margin of safety. Therefore the more numbers he wagers on, the better the chance of gain.
Bottom line: What Benjamin Graham was saying is that margin of safety goes hand in hand with diversification.