FREE NEWSLETTER

In Case You’re Wrong

Adam M. Grossman

“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:

  • Hyperinflation, like Germany experienced after the First World War.
  • Deflation, a phenomenon that induces malaise and economic contraction.
  • Devastation, such as war, natural disasters and famine.
  • Confiscation, as Venezuela has experienced, for example.

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.

Want to receive our weekly newsletter? Sign up now.

Browse Articles

Subscribe
Notify of
8 Comments
Newest
Oldest Most Voted
Inline Feedbacks
View all comments

Free Newsletter

SHARE