Why Is Margin of Safety Important in Stock Investments?

Are you looking to protect your gains in the stock market? Do you want to purchase stocks with minimum downside risk? You may consider studying the margin of safety with stock investments. It is the difference between the stock’s market price and its intrinsic or true value. The margin of safety is a built-in cushion that can minimise your losses in the stock market during periods of extreme volatility. Should you focus on the margin of safety in stock investments?

What is the margin of safety in stock investments?

The famous investor Benjamin Graham coined Margin of Safety. It uses qualitative and quantitative factors such as corporate governance, competitive advantage, assets and earnings, industry performance and so on to determine a stock’s intrinsic or actual value. 

In simple terms, the margin of safety is the purchase of shares when their market price is way below their intrinsic value. For example, purchasing stocks of a company with solid fundamentals may be an inappropriate investment if done at a very high price. The stock price has run up so high that you don’t have much room to make a profit from your investment. 

Is the margin of safety necessary?

The margin of safety follows a concept where you purchase a stock at a discount to its actual or intrinsic value. It can limit your losses if the stock price crashes or allow you to profit from your stock investments. 

The margin of safety protects your stock investments from what Benjamin Graham calls the Unknown-Unknown. For instance, if you have bought a share at a 50% discount on its intrinsic value, the chances of suffering losses are slim. 

The margin of safety helps you pick the appropriate stocks at the right price. For instance, suppose the intrinsic value of ABC stock is Rs 150, which is well below the market price of Rs 200. You could purchase this stock when its market price falls below the intrinsic price due to factors other than the collapse of its fundamentals. It may take some time for this to happen, but you can confidently purchase the share. 

The in-built cushion will protect your investment and allow you to maximise your share profits. If you buy a stock at a price way below its intrinsic value, chances are the stock price will rise with time if the company has solid fundamentals. You can earn superior returns by purchasing undervalued stocks that eventually realise their true potential over time. 

What margin of safety should you maintain?

The margin of safety depends on your preference and risk tolerance. Moreover, it also depends on the risk grade of the stock. For instance, you can have a lower margin of safety for blue-chip stocks than midcap and smallcap stocks. 

The margin of safety also depends on the type of investor. For example, a value investor may prefer a margin of safety of around 40%-50%, whereas a growth investor may be happy with a margin of safety of 15%-25%. 

Remember that margin of safety is an estimate, and you can get it right with good practice. Moreover, it helps to pick stocks of firms that enjoy an economic moat which is a competitive advantage over its rivals and peers. You must pick stocks of companies with an economic moat at a price lower than its intrinsic value to maximise returns over the long term. 

If you follow the margin of safety concept and purchase stocks at a price way below the intrinsic value, chances of preserving your wealth or even maximising profits are high. Moreover, you don’t need to get the stock price right all the time, as even an approximate value serves the purpose. In a nutshell, focusing on the margin of safety encourages you to be a patient investor who buys the right stocks at the right price. 

For any clarifications/feedback on the topic, don’t hesitate to get in touch with the writer at cleyon.dsouza@cleartax.in