Different Layers of Margin of Safety

I won’t delve into why there’s such a strong need to prioritize preservation of capital over return on capital since I want to focus on the different ways we can apply margin of safety to an investment decision. Just note that it’s much harder to earn money percentage wise than to lose money (eg. If you lose 33% money you’d need to earn ~50% to earn back that lost money).

The first margin of safety is never investing with money you can’t afford to lose. If you’re forced to liquidate stocks at extremely unattractive prices to deal with emergencies, then volatility (which academics define theoretically as risk) becomes actual realization of risk of permanent loss of capital.

The second margin of safety is your investment philosophy, and to an extension investment strategy. This provides a framework for you on how to act when the market is up, down or stagnant.

The third margin of safety is your emotional discipline. You can have a framework but it’s no good if you can’t stick to it through the good times and bad times.

The fourth margin of safety is price you pay. Never invest when it is over-valued, the reason is obvious. Also never invest when it is fair valued since that requires an extensive amount of knowledge and intuition to accurately predict on how the company will perform in the future. The less you pay, the larger the margin of safety, the more you can afford to be inaccurate.

The fifth margin of safety is knowing the company and industry well. To be able to see what others see but also see much more than what others see, you can understand where the pessimism of certain stocks are coming from and discern if the pessimism is warranted or not.

The sixth margin of safety is buying quality companies. When you buy and you misjudge on valuations, the sustainability of excellent compounded growth of earnings will help compensate over time. When you don’t sell even though the stocks of the quality companies are extremely over-valued, you are punished less than lesser quality companies as the returns will still be okay instead of bad.

The seventh margin of safety is quality companies that pay dividends. Despite being much less tax efficient than quality companies that don’t pay dividends due to double taxation, predictable dividends allow you to make more accurate personal budget forecasts and thus bigger allowance to invest aggressively with your cash reserves and inflow of income and dividends without risking bankruptcy. It also enhances your ability to borrow to invest without going bankrupt.

The eighth margin of safety is to practice some form of diversification. You have to always cater for the extremely minute possibility of your quality company stocks going to total failure just in case it does happen and completely screws you over. Even Charlie Munger who is famous for being ultra-concentrated practices some form of diversification with his investments, by having at least three companies in his portfolio at all times.

The ninth margin of safety is accumulating cash without investing when no quality companies are under-valued. It helps act as a hedge to compensate for risk of holding onto over-valued quality company stocks for too long and provides dry powder to invest aggressively when compelling opportunities are abundant.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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