Margin of Safety: Price vs. Value

Disclaimer: Please note that all content and information in this blog are for educational and informational purposes only and should not be taken as professional investment advice.

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People avoid buying highly priced assets for fear of looking really stupid if they lose money.

Likewise, people buy lowly priced assets to look less stupid if they lose money.

Being averse to highly priced assets and drawn to lowly priced assets can be both good and bad.

If you buy an undervalued highly priced asset, you will not lose money. But if you buy an overvalued lowly priced asset. you will lose money.

It's not a matter of whether the asset is highly or lowly priced but whether it is under or overvalued.

Many highly priced assets can be undervalued while many lowly priced assets can be overvalued. We should strive to buy undervalued assets regardless of whether they are highly or lowly priced. 

People often associate lowly priced assets with undervaluation but this isn't always true. Many times, lowly priced assets are cheap for a reason — because they have little to no growth prospects or are loss-making. We should avoid such assets.

Highly priced ≠ Overvalued

Lowly priced ≠ Undervalued

Likewise, 

Highly priced ≠ Undervalued

Lowly priced ≠ Overvalued

In short, there's no correlation between price and value.

We focus on the value, not the price. But in order to determine whether to invest or divest, we need to look at the price relative to it's value.

By focusing on value, we can make a fair comparison between value and price to decide if the asset is worth our money.

And most importantly, to ensure the impact of our mistakes is minimised while the impact of our right decisions are maximised, we need to have a margin of safety.

A margin of safety is a buffer in the event our valuation is off, (which unfortunately is often the case regardless of how experienced one is, as even the greatest investors like Warren Buffett or Peter Lynch, make costly investment mistakes). An asset's value is constantly changing and therefore our valuation has to keep up to date with it. And sometimes we may need to change our valuation approach especially if there has been a major shift in the asset's fundamentals.

Since we cannot guarantee that our valuation will be spot-on, we must factor in a margin of safety in our investments. Generally, the larger the better. But it cannot be so large such that it causes us to miss out on many investment opportunities. 

Buying at the right time is as important as buying the right asset.

So while a large margin of safety has its benefits, we must ensure we do not "overkill" by factoring an unrealistically large margin of safety such that it precludes us from investing in most assets just because the price isn't low enough.

Our margin of safety must be reasonably large to avoid making costly investment mistakes while allowing us to invest in good quality assets at a reasonably low price.

The more risk-averse you are, the larger margin of safety you will require.

But what exactly is a margin of safety and can it be quantified?

As said, it is a buffer — specifically, a percentage discount to our fair valuation of the asset. For example, if I value asset A at $X. Logically, I will invest if A's price falls below $X. However, since I cannot be sure my valuation is fully accurate, I need to factor in a margin of safety. For example, 20%. This means if A's price falls to below (1 - 20%) * $X = $0.8X, I will invest.

This ensures if our valuation of A is off (e.g. the actual fair value of A is $0.9X instead of $X as we computed), we will still make money because we factored in a margin of safety of 20%, so we will only buy A at $0.8X, below its true fair value of $0.9X.

Realistically, it is impossible to ascertain an asset's true fair value, and therefore, all investors need to factor in a margin of safety when investing to avoid investing in the right assets at the wrong price. A margin of safety ensures we can still make money despite making mistakes — and that's a really valuable skill in investing.

However, factoring in a too large margin of safety can be costly as well. For example, if our margin of safety is 50%, this means we will only invest in A if its price falls below $0.5X. But what if the price of A never falls below $0.5X? Then we will never get to invest in A, despite it being undervalued even at $0.8X (below true fair value of $0.9X).

In such cases, while we don't lose money, we lose out on a potentially profitable investment. This lost of potential profits is the "cost" we incur for factoring in an overly large margin of safety.

In short, a large margin of safety will cause us to filter out most assets, leaving only a few lucrative ones to invest in. This eliminate many potentially great investments, but it ensures we only invest in assets way below their fair value. So while we may lose out on many potentially profitable investment opportunities, the few investment decisions we make will likely turn out to be extremely profitable because of the large margin of safety.

Margin of safety is inversely related to our valuation accuracy. The more accurate our valuation is, the smaller margin of safety we can afford.

In conclusion, it is impossible to have a 100% accurate valuation all the time, and as such a margin of safety is always required regardless of how good of an investor you are. In fact, utilising the concept of margin of safety will make you a better investor. Those who ignore the margin of safety believe that their valuations are spot-on. While they may be right in some instances, it is impossible to ensure they are able to consistently value assets with perfect accuracy. One mistake is enough to disrupt their investment plan. Therefore, we will need a margin of safety regardless.

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Disclaimer:

The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

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