Benjamin Graham's Concept - Margin of Safety

Benjamin Graham was not only a widely respected author and expert on value investing; he is often credited with creating the foundation for modern fundamental analysis of stocks. Graham created many well known and widely used theories for investors, including the concept of the margin of safety.

Graham advocated value investing. For value investing to work, the investor must find companies that are trading at a market price that is a discount to the intrinsic, or real, value. The difference between the market price and the intrinsic value of a stock is known as the 'margin of safety'.

Because a guiding rule of value investing is first and foremost preservation of principal, the margin of safety is in important concept for making stock and bond choices. Benjamin Graham was aware that prices fluctuate based on emotions, interest rates, news, reports, and other outside forces. To protect the investor, an adequate margin of safety is necessary.

The margin of safety protects the investor from both poor decisions and downturns in the market. Because true value is very difficult to accurately compute, the margin of safety gives the investor room to make a mistake.

It is important to realize that market prices and intrinsic values of a share of stock are not always in synch. By choosing stocks that have a significant enough separation between the two values, a smart investor can snap up bargains with the comfort that a margin of safety can help protect them in the event of a downturn.

An essential element of Graham's concept of margin of safety is the size of the margin. A small margin gives little room for error, so the margin must be large enough to accommodate errors in calculating intrinsic value. In particular, purchasing a company that is trading at a discount to its asset value gives an adequate margin of safety. The theory is that, worst case scenario, if the company fails and is liquidated, the assets will at least be worth the price paid.

A second essential element of the margin of safety concept is the principal of diversification. Graham recognized that no investor is perfect in his or her decision making, and unforeseeable market forces can cause unfavorable market turns for an investment even with a margin of safety. Proper diversification of a portfolio offers additional protection against these events.

The margin of safety concept popularized by Benjamin Graham is the cornerstone of value investing. Buying investments that trade at a significant discount to their book value, in a diversified portfolio, is what the margin of safety theory is all about.