Margin of safety is an engineering concept used to describe the ability of a system to withstand loads that are greater than expected by building reserve capacity or “slack” into the system.
Warren Buffett explains it best with two analogies – one for investing and one for building a bridge:
“You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 tons, but you only drive 10,000 ton trucks across it. And that same principle works in investing.”
Think about it: if a proposed bridge is expected to support 10,000 tons at any one time, do we build a structure to withstand 10,001 tons? I think none of us would feel safe driving on that bridge. What if we get a day with much heavier traffic than usual? What if our calculations and estimates are a little off? What if the material weakens over time at a rate faster than we imagined? That’s why we would build a bridge that can support 20,000 or 30,000 tons. That gives us our margin of safety.
The core idea of margin of safety is to protect yourself against unforeseen problems and challenges by building a buffer between what you expect to happen and what could happen.
When deciding your margin of safety, beware these common issues or “traps”:
- Tradeoff: Margin of safety often involves a tradeoff with time and money. The above bridge could be built to support 100,000 or even 1,000,000 tons…which would obviously require more expensive materials and/or time to be built. At some point you can “fail-proof” something to such an extreme degree that it becomes impractical.
- Systems Thinking: We often apply a margin of safety to one area or component and forget to apply it to the system as a whole. The more components, the more complicated the (interactions within the) system, requiring a larger overall margin of safety.
- “The reliability that matters is not the simple reliability of one component of a system, but the final reliability of the total control system.” – Garrett Hardin
- Naïve extrapolation of past data: Basing our margin of safety calculations on misleading or incomplete past data, too few data points or ignoring the possibility of extreme outcomes (black swan events).
- Example: the insurance industry, when calculating how much capital to have available in case of natural disasters. Basing everything on earthquakes of the past 50 years that went up to a magnitude of 5, but ignoring the once-in-a-century earthquake with a magnitude of 6 or 7.
The future is uncertain and all information comes with some degree of error. You can think of a margin of safety as your reservoir to absorb these errors or poor luck. A protection against the unknown, the random, and the unseen.
The bigger your margin of safety, particularly when it comes to decisions in life, the better. Always leave room for the unexpected. And if you need a calculator to figure out how much margin you have, you’re doing something wrong.
How to use Margin of Safety
In personal finance, we can increase our margin of safety by reducing our expenses and increasing our savings rate.
For example, if we have two couples both earning $ 5,000 a month, but couple A has monthly expenses of $ 4,500 while couple B’s are only $ 2,500. Obviously couple B has a bigger margin of safety and is better prepared to handle any unforeseen circumstances, such as expensive surgery or one person losing his/her job.
That’s why, the lower your expenses (relative to your income), the better and the bigger your margin of safety. If your spending is low enough, even in the case one person loses his/her income, you might not even need to tap into your savings.
A larger margin of safety in your personal finance has an additional benefit: compounding. By systematically underspending your income, your cushion can increase exponentially.
A simple way to get started is to have two jobs (either by yourself or with someone else) and only use the income from one job, while saving everything from the other.
In time management, you may have an appointment at 11:00 am and it takes you (on average) 10 minutes to get to your destination. Give yourself a bigger margin of safety by not leaving at 10:49 but at 10:40 or 10:30, to account for any possible delays.
In project management, it pays to be conservative in your time and cost estimation.
If five people are involved and each requires on average 4 days to complete his/her task, the simple way to decide the deadline is multiplying that average by the number of people: 5 people x 4 days = 20 days.
But when you understand that the possible range of days it takes each person to complete his/her work is anywhere from 2 days to 6 days, it makes more sense to incorporate a margin of safety and go with the most conservative estimate: 5 people x 6 days = 30 days.
The same applies to budgeting: adding the averages of every component in the project proposal may give you an estimated budget of $100,000. But considering a range of outcomes (including best-case and worst-case scenarios), the estimate can range anywhere from $50,000 to $200,000.
In both cases it pays to minimize risk (and disappointment) by building a larger margin of safety and going with the most conservative estimate. After all, we like positive surprises much more than negative ones.
In investing, margin of safety is defined as the difference between the intrinsic value of an asset and its market price.
Our predictions and calculations turn out to be wrong all the time. When it comes to assessing investment opportunities, you want a margin of safety that is so wide, it doesn’t matter if your prediction is inaccurate.
Don’t buy assets worth $100 for $90. Instead, find the ones you can buy for $70. The larger your margin of safety, the lower your risk (of permanent loss of capital) and the higher your potential return (asymmetric return).