How to use a Margin of Safety when Investing

A fundamental part of value investing is to ensure that there is a margin of safety with your investments.

What this means is that you buy a stock when its price is not only lower than or equal to your calculated fair price, but that it’s significantly lower. This provides you with some gray area where your assumptions about the company can be a little bit off, and yet the investment will still turn out okay over the long run.

The margin of safety means that your assumptions would have to be significantly off course for that investment not to work out. But even then, by diversifying across 20+ companies and into other asset classes, the scenario becomes statistical in nature. For example, if you invest in 20 companies, and you only invest when a stock is trading at least 15% below your calculated fair price, then one or two of them can go bad while your overall portfolio will still perform admirably.

In the example of this chart, the time to buy would be when the stock price (red line) falls below the intrinsic fair value (blue line). It’s easier said than done, because you won’t have the benefit of seeing the rest of the chart in front of you, and the intrinsic fair value (blue line) is your calculated estimate of what the stock is worth rather than an absolute truth.

By sticking to sound value investing principles, however, you can do well. As can be seen in the chart, the fair value of a healthy company will be far less volatile than the stock price can potentially be, with only minor adjustments occurring each year based on new information.

This article was written by Dividend Monk. If you enjoyed this article, please subscribe to my feed [RSS]