Why A Margin Of Safety Is Crucial For All Investors

Obtaining a margin of safety could make the difference between success and failure.

A margin of safety is arguably one of the most misunderstood aspects of investing. It’s something which many investors are familiar with, but as a concept its importance is often underestimated. Similarly, it is often over-complicated, which can lead to confusion and a less optimum investment strategy. However, by utilising a margin of safety effectively, it can lead to lower risks and higher potential rewards in the long run.

Simplicity

A margin of safety is simply seeking to buy a company at a discount to its intrinsic value. In other words, if an investor believes a company is worth $1 per share, buying it at $0.80 would represent a margin of safety of $0.20 per share. Put simply, it is a means of factoring in potential challenges which may face the company, both internal and external, and which may affect its share price in future.

Effect on risk and return

By seeking to buy shares for less than they are worth, it may be possible to reduce risk. Clearly, no investment is risk-free, and shares will usually experience some periods of high volatility when held for the long term. However, a stock which trades for less than it is worth may have less downside risk than its sector peers, since the market may have already priced in potential challenges.

Similarly, a wide margin of safety may mean potential rewards are also increased. If an investor is able to purchase a company for less than it is worth, then clearly their gains may be higher than for an investment in a company which is purchased at fair value.

Valuation

Of course, estimating the intrinsic value of a company is never a straightforward exercise. It is hugely subjective and the methods used vary greatly between different investors and different industries.

However, when one investor applies a consistent method of valuing a business across a sector or even an index, it can mean they are able to judge which stocks offer the greatest margins of safety. By focusing on those shares above others, it may be possible to generate a wide margin of safety for an entire portfolio and improve its overall risk/reward ratio. In time, this may lead to improved investment performance.

Psychology

Seeking a wider margin of safety may also help an investor’s mental state. Through buying stocks for what they view as a discount to their intrinsic value, an investor may feel more relaxed even during periods of financial stress when share prices fall. Knowing they have bagged themselves a bargain based on the quality, prospects and financial strength of a business may allow an investor to stay calm during bear markets. It may also enable them to avoid overpaying for a company towards the end of a Bull Run.

Clearly, seeking a margin of safety is a relatively simple idea. However, it can lead to better investment prospects across indices, industries and stocks. As such, it seems to be a crucial part of investing for even the most experienced investors.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

More on Investing

3 colorful arrows racing straight up on a black background.
Investing

1 Canadian Stock Ready to Surge Into 2025

Canadian Natural Resources (TSX:CNQ) stock is a sleeping dividend giant that may be about to wake up.

Read more »

Tractor spraying a field of wheat
Investing

Is Nutrien Stock a Buy for its 4.7% Dividend Yield?

Nutrien (TSX:NTR) is a well-known defensive commodities play. But is this stock worth buying for its dividend yield alone?

Read more »

Happy shoppers look at a cellphone.
Tech Stocks

So You Own Shopify Stock: Is it Still a Good Investment?

Shopify (TSX:SHOP) stock has had a run, but there's still room to the upside.

Read more »

Paper Canadian currency of various denominations
Investing

The Best Stocks to Invest $2,000 in Right Now

Do you have some extra cash to spare? Here are three Canadian stocks to add to your watch list today.

Read more »

tsx today
Stock Market

TSX Today: What to Watch for in Stocks on Friday, November 22

Continued gains in gold, oil, and natural gas prices could give the commodity-focused TSX benchmark a boost at the opening…

Read more »

Train cars pass over trestle bridge in the mountains
Dividend Stocks

Is CNR Stock a Buy, Sell, or Hold for 2025?

Can CNR stock continue its long-term outperformance into 2025 and beyond? Let's explore whether now is a good time to…

Read more »

engineer at wind farm
Energy Stocks

Invest $20,000 in This Dividend Stock for $100 in Monthly Passive Income

This dividend stock has it all – a strong outlook, monthly income, and even more to consider buying today.

Read more »

Hourglass and stock price chart
Stock Market

It’s Not Too Late: Invest in These TSX Growth Stocks Now

Solid fundamentals of these top TSX growth stocks could help them maintain strong upward momentum in the years to come.

Read more »