Margin of Safety: Secret of Sound Investment

Benjamin Graham (May 8, 1894 – September 21, 1976), the father of value investing, summed up the secret of sound investment in three words: margin of safety. This was in his book, The Intelligent Investor.

Warren Buffett, Benjamin Graham’s most famous disciple, explained his mentor’s margin of safety concept this way (Source: The Superinvestors of Graham-and-Doddsville by Warren E. Buffett): “You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin (of safety). When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”

In Chapter 20 (“Margin of Safety” as the Concept of Investment”) of The Intelligent Investor, Benjamin Graham summed up the chapter by saying: “Investment is most intelligent when it is most businesslike”.

“If a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success,” said Benjamin Graham. In other words, view a corporate security as an ownership interest in a specific business enterprise.

Benjamin Graham listed four sound business principles and explained how they were related to the securities investor:

(1) “Know what you’re doing – know your business.” Benjamin Graham said that the investor should not try to make “business profits” out of securities – that is, returns in excess of normal interest and dividend income – unless “you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in”.

(2) “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor, it means understanding the conditions under which he will permit someone to decide what is done with his money.

(3) “Do not enter upon an operation – that is, manufacturing or trading in an item – unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” The enterprising investor should make sure that his operations for profit should not be based on optimism but on arithmetic. For every investor who limits his return to a small figure, such as in a conventional bond or preferred stock – he needs to ask for convincing evidence that he is not risking a substantial part of his principal.

(4) “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even others may hesitate or differ.” “In the securities world, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand,” said Benjamin Graham.

Related post: Benjamin Graham’s theory of diversification