No matter how wonderful a business is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.
— Charlie Munger
No matter how smart or confident you (think you) are, it would be foolish to assume that you know everything, all is in your control, and nothing would go wrong. There are unknown unknowns lurking around. You need a Margin of Safety in your bets. Always!
The concept is not new. It’s a cornerstone of engineering. Engineers design systems to withstand significantly more emergencies, unexpected loads, misuse, or degradation than would normally be expected. For example, if you are required to build a bridge to support 2,000 tonnes, you would build a structure that can support 10 times that. A lot of things can go wrong. And if they do, the downside is just too high.
What if there’s more traffic than usual? What if the material weakens at a faster rate due to climate change? What if there’s corporate investment which increases job opportunities in the area, and the regular traffic tripples? To account for these, and several other things you cannot account for, you would build the bridge to support at least 20,000 tonnes (even though it costs more) to have a decent Margin of Safety.
In 2011, the Fukushima Daiichi Nuclear Power Plant in Japan was overwhelmed by a tsunami, creating a nuclear disaster as bad as Chernobyl. Their Margin of Safety to deal with the weather of the recent past was good enough. But preparing for the past isn’t the same as preparing for the worst that is yet to come.
Even though a tsunami wasn’t predictable, it certainly was a possibility (given the seismic activity of the area). The plant wasn’t designed to withstand a tsunami. Why? It was too expensive. More safety meant more money. They didn’t factor in the severity of the downside. The ensuing disaster was a Level 7 event classification of the International Nuclear Event Scale. The scale runs from 0 to 7.
The core idea behind Margin of Safety (MoS) is to protect ourselves from unforeseen events by creating a buffer between what we expect to happen and what could happen. Notice how the fuel indicator starts blinking long before the tank is empty? It’s the same idea.
MoS, although easy to understand, is often neglected—in business valuations, growth projections, product releases, and effort estimates.
If it takes 30 minutes to reach office, leaving 35 minutes before a meeting is ignoring MoS. If you think a project would take 30 days to complete, committing exactly 30 days is being naive. If you are driving while texting, you don’t have any MoS.
Margin of Safety gives you the cushion to recover from your bad estimates and poor predictions. It acts as a shield against Murphy’s Law: Anything that can go wrong will go wrong.
Utilising an MoS can serve you well in nearly any area of life. It doesn’t completely eradicate failure (nothing can), but it can help you deal with risk, uncertainty, and your own ignorance—as long as you don’t blow it out of proportions.
When you go overboard with MoS—for example giving yourself a 6 month cushion for a 1 month project, or keeping an MoS of $80 million to buy a $60 million business—it stops being helpful.
In the real world, there’s always a tradeoff with time and money. Therefore it’s impractical to become “completely fail-proof”. You can realistically aim for “unlikely to fail” and set your MoS accordingly. Flying an aeroplane isn’t completely fail-proof, but all the safety precautions make it less likely to fail.
You don’t need to put MoS everywhere—especially where there’s very little or no downside. Otherwise, your life would be all margin and no living.
In other cases, you would have to tweak your MoS according to the severity of the downside. If you are late to come home sometime, it may be fine. But if you are late on your kid’s birthday, it is not fine. Adjust your MoS accordingly.
“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need.”
— Warren Buffett
A good strategy is to identify the unlikely (but possible) risks, and have enough MoS so that your normal life doesn’t hamper even if unwelcome events come to pass. For example, if you identify 50 ways your revenue might decrease, and keep enough money in the bank, a bad month (or even a bad year) will be absorbed without any serious jeopardy.
If you are spending all the money you earn, even the slightest unexpected expense can put you on your knees. Whereas, if you save 30% of your income every month, it compounds over time, and gives you a lot of financial stability in the long run.
Leave room for the unexpected. Always! All information—no matter how bulletproof it may seem—comes with some degree of error. Things get more complicated with time. A Margin of Safety acts as a buffer against the unknown, the random, and the unexpected.
The unexpected is just that: not anticipated. That doesn’t mean it is impossible. The unexpected is not the worst thing that has happened before. It is the worst thing, given realistic parameters, that could happen. Guard yourself against it.
The world is uncertain. There is too much information with too many moving pieces. Your calculations are error-prone. But you have to be confident enough that you would be able to handle life’s risks and uncertainties despite your shortcomings. Margin of Safety gives you that confidence.