Margin of Safety
One of the first things you learn when learning how to drive a car is to maintain a safe distance from the car in front. In case the car brakes suddenly, you need that extra distance to make sure you do not rear-end the car in the front. Tailgating removes the ‘margin of safety’.
The same idea is applicable in personal life and business. When going for a meeting, I keep a margin of safety to ensure I am not late. When running a business, it is important to have the cushion of cash each month just in case some customer payments are delayed so you are not caught in a cashflow bind.
Margin of safety comes from the world of investing. Here is a brief from Investopedia:
Margin of safety is a principle of investing in which an investor only purchases securities when their market price is significantly below their intrinsic value. In other words, when the market price of a security is significantly below your estimation of its intrinsic value, the difference is the margin of safety. Because investors may set a margin of safety in accordance with their own risk preferences, buying securities when this difference is present allows an investment to be made with minimal downside risk.
Alternatively, in accounting, the margin of safety, or safety margin, refers to the difference between actual sales and break-even sales. Managers can utilize the margin of safety to know how much sales can decrease before the company or a project becomes unprofitable.
Here is more from Rule on Investing:
Warren Buffett said, “The three most important words in investing are margin of safety.” That means to buy stuff on sale. That means pay less than what it’s worth. That means to buy $10 dollar bills for $5 dollars. That’s the whole secret to great investing.
Buffett’s teacher Ben Graham, who wrote the Intelligent Investor, which is one of the best books on investing I’ve ever read said, “Buy stocks the way you buy groceries, not perfume.”
One of the keys to getting a great margin of safety is to understand that price and value is not the same thing.
Margin of safety is critical in the early stages of a business. I was talking to a person who was just starting a business and planning to raise some initial capital from family and friends. I asked him: how long before first revenues come in, and how much money will be needed till then? He had planned it perfectly. It was then I asked him: “What if things don’t go as per plan? What if it takes longer to develop the product and get first revenues? Where is your margin of safety?” My recommendation was to increase the runway by raising more money to keep a buffer in case things take longer.
Optimism is good, but keeping a margin of safety is better!
Tomorrow: Part 44