Margin of Safety Investing Strategy

Margin of Safety is one of the most popular value investing strategies made popular by stock market legends like Benjamin Graham (father of value investing) and Warren Buffet. Margin of safety is simply a value stock investing model where the investor assigns a margin of safety to his/her value assessments.

In value investing, the investor estimates (or predicts) the intrinsic value of a stock. The concept is that every stock has an intrinsic value and price changes from this intrinsic value is just deviations resulting from the actions of market forces. The stock will often return to its intrinsic value when the market forces weaken. Thus investors who buy stocks when the trading price is below the intrinsic value and investors who sell stocks when the trading price is above the intrinsic value will profit.

But what make value investing difficult is predicting the intrinsic value of stock. There are no established rules for finding out this. Investors should develop their own strategies and models for this purpose, according to availability of information and analysis tools he has. Many traders use different indicators like book value, open offer, P/E ratio, asset to liability ratio, institutional investments, investments in other companies, etc to finding the intrinsic value of the stock.

Margin of safety investing strategy easily overcome this difficulty of predicting the intrinsic value. Investors assign a safety margin as percent of predicted intrinsic value (usually is 30 to 40 percent of intrinsic value). Margin of safety investors only buy stocks when they are trading below margin of safety. In this way he/she can minimize the risk/error of predicting the intrinsic value. The more the percentage of margin of safety the lower the chance of risk, and the better the chance of profit.

For example is the predicted intrinsic value of a stock is $10 and margin of safety is 30%, then the trader only buys the stock if the current trading price is below $7 ($10 – 30% of $10). If the actual intrinsic value is only $9, and the stock returns to this level, the investor will have a profit worth $2.

The main advantage of margin of safety investing strategy is that it offers a margin rather than a fixed price to reduce risk. It favors all type of investors, both experienced and novice investors, and does not necessitates any position sizing or market performance requirements. But the disadvantages are that it does not present any rules for assigning margin of safety and does not consider market factors. Also there is chance of substantial loss when margin of safety is less and scarcity of opportunities when margin of safety is high.