The central concept of investing
In this post I want to explore another use of the concept of ‘margin of safety’. We mostly think of it in the buying and selling of individual stocks. I want to discuss it from the point of view of structuring all our finances.
Ben Graham’s idea
Everyone has heard of Ben Graham’s concept of ‘Margin of Safety’. In essence, his advice is that when doing your due diligence around the purchase of an investment you need to build in a margin of safety to allow for the inherent uncertainty of the valuation and investment process.
I’ve also thought that buying a stock with a substantial margin of safety between the intrinsic value of the stock and the price paid probably also serves to increase future returns.
Ben Graham introduces the idea in Chapter 20 of The Intelligent Investor. It is titled ‘“Margin of Safety” as the Central Concept of Investment’. He puts it this way:
“In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secrets of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy – often explicitly, sometimes in a less direct fashion.” (Graham, The Intelligent Investor, 1973) p.277
In chapter 20 he discusses Margin of Safety in relation to individual security purchases.
Webster’s dictionary includes among its definitions for margin, “something that is over and above what is strictly necessary and that is designed to provide for emergencies: a spare amount or measure or degree allowed or given for contingencies or special situations.”
It is a term used in engineering and other disciplines.
For at least the last twenty years I have been applying it in relation to our family’s finances. Let’s look at that.
Margin of safety in investment and financial planning
I should explain, by way of background, that since we started saving and investing for our retirement almost 50 years ago our asset allocation has for the most part been 100% stocks. Since the fall of 2002 it has been exclusively stocks and in a concentrated portfolio. The philosophy behind this has been to take advantage of the long term outperformance of stocks over bonds. It involves investing only in superb companies and then only at very attractive prices.
The downside of this approach is volatility and the ever-present threat of a kind of Armageddon. Our approach has been to try to avoid getting mauled in the busting of a bubble. So, for example, we sold essentially all our stocks and went to two year bonds in 1998 and only went back into the stock market in the fall of 2002. Next time we may not be so lucky. Hence, we have to proceed on the assumption that our financial assets at some point could take a 50% hit. A worst case scenario would be a drawdown of that magnitude followed by a recovery that takes 20 years, somewhat like the Japanese experience beginning in 1990.
Over the years I have asked myself this question: What would happen to our family’s wellbeing in such a situation? Specifically, the question is: how would our family get along if half our financial assets got wiped out? The answer is that we would not lose our house. We would be able to live a modest but not uncomfortable lifestyle. We would be comforted that in such an Armageddon scenario our friends would also be in more constrained circumstances.
I came to the conclusion years ago that our financial assets provide a cushion, “something that is over and above what is strictly necessary and that is designed to provide for emergencies.” Our idea with investing has been to earn the best returns we reasonably and prudently can and then live within our means.
The great Financial Crisis of 2008 provided a good test. We came through just fine. Since it was not a stock bubble but a subprime crisis, derivatives crisis and financial engineering crisis all wrapped into one, it did us no long term damage.
Our investment plan for 2022
Currently we are not planning any asset allocation changes. We sold one stock in 2021 and substituted one new one. What I wrote last year about our plans for 2021 is still valid for 2022. See here. As I wrote at that time: “we have a new year to look forward to. I don’t have any fundamental decisions to make at this point. My game plan was made years ago.”
Conclusion
It simply remains for me to wish all readers a Happy New Year. Good luck to all of us in our investing.
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In 1974 Ben Graham remarked in a speech that investing did not require genius: “What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.” (Lowenstein, Buffett, The Making of an American Capitalist. 1995,2008) p.160 (emphasis added)
To read further about how to go about investing check out the Motherlode Part 4: Principles of Operation
In particular, see these Chapters:
24. Business objective
25. Investment Styles
26. Buying with a margin of safety
27. Sound Principles of Operation
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You can reach me by email at rodney@investingmotherlode.com
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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