How to protect your investments against potential risks and losses

The margin of safety (hereafter called ‘MoS’) is a principle of investing in which an investor only purchases securities when their market price is significantly below their intrinsic value. 

MoS is a percent difference between the intrinsic value of a stock and the current price, calculated as “MoS = (Intrinsic Value – Market Price) / Intrinsic Value”. The wider the margin, the better the in-built cushion that allows a few losses but protects against major losses for overly optimistic valuations. 

The market price is defined as the prevailing price of a security, traded in the real market and is based on supply & demand dynamics. Intrinsic value is a perceived or calculated value of an investment that factors in a company’s assets, earnings potential, dividend, quality of management team, intellectual property and brand recognition. Investors utilize both qualitative and quantitative factors to determine a security’s intrinsic value. Investors & analysts may have different methods of calculating intrinsic value and rarely are they exactly accurate and precise. And it’s not easy to predict a company’s earnings or revenue. 

MoS principle was popularized by Benjamin Graham. Warren Buffet applies a 50% discount to the intrinsic value of a stock when determining its price target. He builds the MoS in case his estimates are incorrect or biased. The intrinsic value is difficult to know; even Buffet struggles with it.

While MoS doesn’t guarantee a successful investment, it acts as a cushion against errors in judgment or calculation. Each investor can set their own MoS based on their risk tolerance. A very risk-averse investor may only consider buying stocks that are trading 30% (example) or more below their intrinsic value but a less risk-averse investor may be willing to buy those that are trading less than 10% (example) below their intrinsic value. 

Let’s look at the correlation between the Margin of Safety and other critical investing principles. 

Risk Mitigation

MoS plays a pivotal role in mitigating investment risk. Financial markets are unpredictable and subject to sudden shifts influenced by various factors. Incorporating a safety margin shields portfolios from losses and fosters a resilient investment strategy.

Consider two stocks, Company A and B. Investors have calculated the intrinsic value to be $100 each. Company A is currently trading at $50, B at $90. MoS for A is 50%, for B, it is 10%. Basis MoS, Company A seems to carry a low risk. 

Investors have likely miscalculated the intrinsic value due to any factor(s) such as unexpected changes in the company’s financials, sudden negative events leading to a drop in the stock market, a natural disaster, etc. In such scenarios, a Company with a higher MoS cushion will have more room to drop in value before the investment results in a loss. 

Preservation of capital 

Preserving capital is a conservative investment strategy with the primary goal of avoiding losses in a portfolio. MoS aligns with this objective by providing a safety net and helps prevent significant capital erosion during market downturns. The central thesis (or first rule) of value investing is around preserving capital. By ensuring a margin of safety, investors aim to protect their invested funds. For risk averse investors or those nearing retirement, this is a crucial strategy. It safeguards wealth over speculative gains. 

Long-term perspective

MoS contributes to both immediate protection and long-term stability. Investors with a long-term perspective appreciate that markets can be volatile in the short term. They emphasize intrinsic value over market noise that enhances portfolio durability. Having a MoS provides peace of mind; a psychological comfort that if things don’t go as planned, the financial buffer offers reassurance. By looking beyond short-term fluctuations, investors build portfolios that withstand, market volatility and endure over time. 

Value investing principle

The key to value investing is to find stocks with a good MoS, or plenty of upside potential. Buying stocks at bargain prices gives a better chance of earning a profit later when they are sold (i.e. “Buy Low, Sell High”). MoS also makes it less likely to lose money if the stock doesn’t perform as expected. 

Other tenets of value investing are – patience (holding onto undervalued stocks until their market price aligns with their intrinsic value), long-term (it is not about quick gains but about long-term wealth creation); fundamental analysis (scrutinizing financial statements, industry trends and company perspective to identify value opportunities); thorough research, discipline, and a contrarian mindset, even when the market behaves irrationally.

Key Metrics

MoS is a crucial financial ratio. It’s an investment theory suggesting that securities should be purchased only when their market price is below their intrinsic (inherent) value. In other words, investors seek a cushion against potential losses by buying assets at a discount. A higher MoS increases the likelihood of positive returns on investment. 

Diversification

Diversification involves owning a mix of assets in a portfolio to reduce risk. Achieved by spreading investments across asset classes, sectors and geographies. While it cannot eliminate systematic risks but it largely addresses unsystematic or idiosyncratic risks. MoS focuses on investing in assets with a lower risk of loss. Look for undervalued stocks with low price-to-earnings (P/E) ratios, high dividend yields, or strong balance sheets. Combining diversification and MoS can build a resilient portfolio to weather market volatility and generate decent returns over period of time. 

Continuous Monitoring

Establishing a MoS is not a one-time activity. As circumstances evolve, regular evaluation and adjustments are required. Eg: monitoring market trends, company performance & economic indicators. Benefits include; timely corrections, enabling adjustment to changing conditions, and proactive monitoring to prevent costly failures. MoS and continuous monitoring work hand in hand. The former provides a buffer against risks, latter ensures timely adjustments for safety and efficiency.