“MARGIN OF SAFETY” is a concept with deep roots in finance, going back at least as far as Benjamin Graham’s Security Analysis, first published in 1934. The idea: Investors should never be too confident in any analysis and should leave the door open to the possibility that their analysis might be right but not precisely right.
Suppose you’re interested in buying Microsoft stock. And suppose that, after analyzing it, you concluded that it was worth $330 a share. With the stock around $280 today, that might look like an attractive investment. If the stock rose to $330, you’d earn an 18% profit. That’s not bad.
But what if things didn’t work out precisely according to the numbers? Then that profit might not materialize. That’s where you’d apply a margin of safety. In this case, Graham might have recommended you wait and only buy the stock if it dropped to, say, $250. That would allow you to come out ahead even if the stock didn’t get all the way to $330.
Since Graham’s time, margin of safety has become foundational for value investors. That’s why Seth Klarman, a hedge fund manager and one of history’s most successful value investors, titled his 1991 book Margin of Safety. Because of this association with Graham and Klarman, the notion of margin of safety is seen mostly as a concept within the limited domain of investment analysis—and, even more narrowly, within the domain of value investing.
It is, however, an idea that I think is more broadly applicable within personal finance. At times of uncertainty, margin of safety seems like an especially important idea to revisit. In his book The Psychology of Money, Morgan Housel articulated the key benefit: “Room for error lets you endure a range of potential outcomes.” Let’s look at how this applies in practice.
In the past, I’ve often come back to the idea that forecasting is a fool’s errand. I still believe that. But that also poses a problem: How can anyone plan for the future if the future is unknowable? The idea of a margin of safety helps reconcile this inherent contradiction.
As you think about your financial future, you shouldn’t be too precise with your assumptions—just as you shouldn’t be too precise in forecasting where Microsoft’s stock will go. What you can do, though, is consider a range of potential outcomes.
In making a long-term plan, you might guess that the stock market will return 7% a year. That sounds reasonable. But there’s no guarantee it will work out that way, so I wouldn’t build a plan around that one assumption. Like Graham, you might want to make sure that your plan will still work even if market returns are lower—just 5%, for example. The key is that these numbers—whether 7% or 5%—aren’t predictions. Instead, you’re simply testing various scenarios to see how things could potentially pan out.
In building a plan, you might test ranges around each of the key variables. This would include your projected retirement date, life expectancy, inflation and future tax rates. Again, the key is that you aren’t predicting—since there’s no way to predict. Instead, you’re simply exploring what would happen under various scenarios.
This approach doesn’t guarantee success, of course. No amount of planning could capture every conceivable outcome. But there are still steps you can take in the face of uncertainty. Harry Browne—an investment advisor, author and erstwhile presidential candidate—encouraged investors to think as broadly as possible about risk when building portfolios. Specifically, Browne highlighted four extreme scenarios:
Picking up on Browne’s idea, author William Bernstein calls these “deep risks” because they’re risks that could result in permanent loss. That’s in contrast to temporary losses, which is what investors usually think of when they think about risk.
These are admittedly extreme scenarios. In making a financial plan, can you really protect yourself against these kinds of risks? Browne’s view was that you could. He recommended constructing what he called a “permanent portfolio” consisting of four assets: stocks, long-term government bonds, gold and cash.
Do I recommend this specific mix? No. But I do agree with the premise at a high level. Diversification is one of the most powerful tools available. And I agree with Browne’s fundamental recommendation, which is to diversify across asset classes that exhibit little or no—or even negative—correlation with each other.
Diversification isn’t the only tool that can provide you with a margin for error. As you review your financial situation, you’ll want to look for other levers. For example, if you have a mortgage or other debt, consider paying it down. Another idea: If you haven’t yet claimed Social Security, consider delaying it as long as possible to accumulate the largest possible benefit. While they aren’t a product I normally recommend, income annuities can definitely play a role for some retirees. Each of these would provide a valuable margin for error if things got tight down the road.
What about bitcoin? I hear this question a lot. While I don’t generally recommend it either, cryptocurrency has an important and unique characteristic: It’s borderless. It isn’t subject to any government’s authority and it isn’t tied to any country’s currency. An asset like this would be invaluable today to refugees fleeing a tyrant in Europe. While I still have a number of concerns about cryptocurrency, I do appreciate that it carries this benefit. I hope it evolves and becomes a valid tool for expanding one’s margin of safety.
The benefits of maintaining a margin for error aren’t merely financial. There’s also an important peace-of-mind benefit. In her book The Happiness Project, author Gretchen Rubin described how she overhauled her life. One of her simple strategies: She left a shelf empty in her closet.
Why? Rubin says it offers her a dose of happiness each time she sees the shelf. To her, it provides a symbolic margin for error in her daily life. She has no plans to use it—but she knows she could. That, in and of itself, is a benefit. It’s the same with your finances. If you can identify levers that offer you a financial margin for error, the benefits could be significant.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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Agreed to all points and comments. What helps me to determine the necessary “MOS” is assessing the probabilities of various outcomes, especially the extreme scenarios the author mentioned, as well as what happens if in fact they do occur. The higher the probability of occurance, and the more disastrous the resulting outcome, the more MOS I need. Yes, all of this is exactly unknowable but some degree of assessment is necessary or we will be far too conservative.
I would add another concept to consider for retirement planning that we use unconsciously every day of our lives during our pre retirement and post retirement lives. It is the concept of fixed and variable expenses. Every day we make decisions to purchase goods or services. Some of those decisions are for goods and services that are intermittent like that of a new car, bigger house or wide screen TV. Other decisions are for services that we have locked ourselves into based on a prior decision for at least a minimum period of time like that of a house payment, utilities, taxes, insurance. Things like food and clothing are fixed to a certain extent unless the person is overly extravagant. Nobody likes the term “budget”. However, a budget is a “A systematic plan for the expenditure of a usually fixed resource, such as money or time, during a given period”. Many people think of BUDGET as one those “4 letter” words that happens to have 6 letters. Given that, for most people, their income is often relatively static, at a minimum we tailor our expenses to at least meet the fixed portion of our expenses.
What does this mean for retirement? It means that many retirees need to focus upon what will be the level of their fixed expenses(rent, buy or sell and buy smaller or larger home, need insurance and the associated utililties, other insurance and taxes associated with that rent, buy or sell decision). Not always, but this can be a relatively straightforward calculation. Therefore, retirement planning step 1 is to decide how best to cover those fixed expenses through SS, pensions, annuities. Step 2 is how to cover those variable expenses via their retirement assets. There is a lot less pressure to beat the market when most of the expenses being covered by retirement assets are relatively, though not entirely, discretionary. It is not necessary to invest as agressively when one knows that there are enough assets available to cover housing, taxes, insurance, old age costs before considering how much the retirement portfolio is growing or falling. It makes retirement planning a relatively simple exercise, assuming of course you have had a relatively lifelong flow of steady earned income, no major health disabilties, not a large student loan debt, relatively few costly divorces and some common sense.
Good and relevant article. Thank you!
One of the challenges with MOS is how much is enough? Some people overestimate and others underestimate. Overestimating risk might help you sleep better but makes it more difficult to achieve your financial goals. The trick is to find the right balance for a MOS. Having a clear understanding of your risks and what level you are willing to accept is the first step to developing a sound financial plan.
Very good article. I agree with the premise of trying to have a margin of safety “in case you’re wrong”. In fact, I’m struggling to come up with an aspect of life where it doesn’t apply. For example, I’m an experienced hiker and I’m pretty good at anticipating what I’ll need on my hikes. Nevertheless my backpack always contains things I don’t expect to need (eg. flashlight, extra food, etc) so it even applies to just enjoyable hobbies.
Very helpful post, Adam! In contrast to Harry Browne’s four investment buckets, I subscribe instead to the 4-legged planning approach others have endorsed on HD in the past:
1) Protection (via Insurance)
2) Savings (sufficient liquidity access via bank instruments)
3) Investments (via equities, in both TQ and non-TQ buckets)
4) Defined benefit income streams (pension / social security / annuity income)
Though I cannot control some of the global issues outlined in Browne’s doomsday list, I can control and plan for more localized (and statistically more likely) personal financial doomsday events (premature death / disability / long-term illness / outliving one’s asset balance).
Great article Adam. MoS is one of my favorite concepts in life.
I wrote about it a few years ago at https://humbledollar.com/2020/10/margin-of-safety/. You do an especially good job of explaining the difference between predicting actual performance vs. testing scenarios in extreme cases. This was a challenge even with experienced engineers.
In addition to the variables you discuss, here are a couple of additional variables I considered as my wife and I moved towards retirement – housing & employability.
At that time we owned two houses, both in very desirable areas. I was pretty sure we could sell or rent out one if needed. If things got really bad we could sell both and move to a more modest cost of living area.
Another thing to consider is how employable are as you approach retirement. After stopping full-time work I maintained work relationships and built new ones. I have been able to do some consulting every year with very little marketing effort. If required I could probably find full-time engineering work. My wife is an extremely experienced nurse, licensed in 3 states. If needed she could have continued working.
I’m not sure how to handle devastation or confiscation. Storing gold implies there is someone else willing to trade useful items (food, medicine, supplies) for gold. I guess it depends on how widespread the devastation is.
Great article Adam. Margin of safety is a concept that isn’t talked enough about in a way that the average retail investor can apply it.
It’s doubly nice to see Browne‘s permanent portfolio mentioned… I back tested his permanent portfolio last year and it did surprisingly well almost 40 years after he wrote about it. I think his ideas have greatly influenced Ray Dalio in his “all weather portfolio”.
Bernstein’s book Deep Risk is a must read. Your idea of maintaining a margin of error is spot on for guarding against these deep risks.