Margin Of Safety

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DEFINITION

A principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk. 

The term was popularized by Benjamin Graham (known as "the father of value investing") and his followers, most notably Warren Buffett. Margin of safety doesn't guarantee a successful investment, but it does provide room for error in an analyst's judgment. Determining a company's "true" worth (its intrinsic value) is highly subjective. Each investor has a different way of calculating intrinsic value which may or may not be correct. Plus, it's notoriously difficult to predict a company's earnings. Margin of safety provides a cushion against errors in calculation.

INVESTOPEDIA EXPLAINS

Margin of safety is a concept used in many areas of life, not just finance. For example, consider engineers building a bridge that must support 100 tons of traffic. Would the bridge be built to handle exactly 100 tons? Probably not. It would be much more prudent to build the bridge to handle, say, 130 tons, to ensure that the bridge will not collapse under a heavy load. The same can be done with securities. If you feel that a stock is worth $10, buying it at $7.50 will give you a margin of safety in case your analysis turns out to be incorrect and the stock is really only worth $9.

There is no universal standard to determine how wide the "margin" in margin of safety should be. Each investor must come up with his or her own methodology.


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