Understanding Margin of Safety

Warren Buffett, Ben Graham, and many other successful investors have talked about margin of safety. There are components you can understand and apply to more situations than investing.

The pieces to understand

The world is neither very specific nor precise. Buffett offers a thought about you driving a truck that weighs 9,800 pounds. You come to a bridge with a sign “Weight limit 10,000 pounds.” Do you cross? Maybe not. If it is convenient enough to go to a stronger bridge, you do. If there is no such bridge, you run down a checklist.

  • Have you crossed this bridge before?
  • Are the conditions the same today? No rain accumulated on the bridge, for example.
  • How sure are you of your truck’s weight?
  • How long ago was the bridge tested?
  • Was there a buffer in the calculation?
  • Has anything changed with age?
  • Was the truck weighed with you in it?
  • How much fuel have you burned since you weighed it?
  • Has anything else been added?

All pretty simple things, and you might go through them automatically.

Investments and Life

Investing and life are more complex because there are more variables, and they play out over a long time.

The points you consider are:

  1. Do I understand the external risk? The bridge
  2. Do I understand my own situation? The truck?
  3. Do I understand how things may have changed from expectation? Old bridge.
  4. Do I know how they will change in future?
  5. Do I know what I will do when they do change?

Consider investment

  1. Does the business have an advantage over its competitors?
  2. Cost leadership?
  3. Market share?
  4. Strong installed product base?
  5. Competent executive managers who understand their role is to lead, not do. Their principal decision is asset allocation.
  6. Competent administrative management. That’s where control and cost leadership begin.
  7. Strong balance sheet. The world is volatile. There must be room to suffer a weak year or other adversity.
  8. Strong cash flow. Income is almost completely opinion. You can’t fool cash and cash flow.

Most of these fall out of management style and their history. You can assess that, yet few investors do. Think about it this way. If a company is doing poorly and changes management, it is difficult to swing it back to success. On the other side, if management has been careful and competent for years, it will be hard for them to become incompetent. Change is difficult.

Consider your financial life.

Everyone has three plans, whether they formalize them or not.

  1. The long-run is from now to a year or so after death. There will be some highlight points along the way, but the idea is to have your ability to finance and enjoy life. Be sure your money resources last longer than you do.
  2. The intermediate plan runs from where you are at some point to the next highlight. From now to the next highlight point, it Could be until forming a family, paying off a mortgage,  educating children, retirement, first death, and settled estate.
  3. The short-term is this year’s cash flow and continuing decisions for the other plans.

It pays to formalize those plans. Life makes more sense when you know why a decision is necessary. Your own chosen why motivates.

What those plans will force you to notice and do

  • You are an emotional being, and adversity will bring out your worst tendencies unless you prepare for it. Planning and anticipation of possibilities minimize that.
  • Knowledge is not power unless you combine it with skill, anticipation, and experience (yours or others.)
  • Curiousity is a huge advantage. Curious people are more connected to their external environment. That allows them to anticipate better. If you paid attention, you knew by early summer 2021 that inflation was coming. How did you know? People were spending money again. No boats for sale at the boat dealer. Cars are in short supply, governments spending money without even keeping track of it.
  • Printing money has little immediate effect on inflation. It only shows up when people spend the newly printed money.
  • Understand yourself. You have certain personal skills that carry over. Your job may give you insight into a sector of the economy. Your personality may include a big piece of neuroticism. That will cause you to overreact to risk and adversity. Or it may be low, in which case you may take unwarranted risks or fail to see signals.
  • If you have a strong support team, it is easier. Courage, balance, and attachment to goals work better when the team decides.
  • Personal networks help you share curiosity and things you have observed. Be sure to build one and support the others in it.

The bits to take away.

Life is easier if you are not operating at 100% of the possible.

Learn to use plans as an anticipation and defence tool.

Reduce stress and anxiety. Both of those reduce decision-making effectiveness.

Apply the same ideas to other life challenges.

When you understand margin of safety, you automatically know one of the important planning variables. Look for the meaning and act on it.

Help me, please. Please subscribe. If you have found this article helpful, forward it to others.

I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Business Development Bank.

Be in touch at 705-927-4770 or by email at don@moneyfyi.com.

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