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How to invest using a ‘margin of safety'

by , 29 April 2015

The father of value investing Benjamin Graham coined the term ‘margin of safety'. Over recent years, the term has become synonymous with Warren Buffett. Graham mentored Buffett as a young investor.

So what does the term margin of safety mean? And how can you apply it to your investment strategy?

Read on to find out…

How can you invest with a margin of safety?

Investing with a margin of safety means you should only invest in an asset when you can buy it for less than it’s really worth. In other words, you can invest in it for a lot less than its intrinsic value.

The idea behind this investment strategy is no-one knows what the future holds.

By investing in an asset, such as a share, at a price that’s lower than it’s really worth and the market falls, you’re less likely to lose money. If you invest in assets when they’re trading at a higher price, you’re more likely to be worse off.

A margin of safety describes the gap between the true value of an asset and the price you pay. For example, the price you pay for a share should be a lot less than its true value.

What margin of safety should you use?

The margin of safety you use if you follow this as part of your investment strategy is very much down to you.

But a minimum margin of safety of 25% or more is a sensible option.

Let’s see how this would work with the help of an example…

You’ve analysed Company ABC’s net assets. You think Company ABC’s shares are worth 100c each. To give yourself a margin of safety, you decide you’ll only invest in the shares if they trade at 70c or below.

By sticking to this margin of safety, you worry less about your investment. And you increase your chances of making money from the investment.

The lower the price you buy into an asset at, the greater your profit potential.

If you find the share you want to invest in doesn’t fall to a low enough price, you shouldn’t invest. You need to wait until the price of the share falls to a level that gives you this margin of safety.

So there you have it. How to invest using a margin of safety.

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How to invest using a ‘margin of safety'
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