Margin of safety (2): in practice
Why a margin of safety needs diversification, how Graham used it to tell investment from speculation, his four business principles, and Zweig on the cost of a big loss.
FinanceGraham ch. 20About 7 min: 4 reading, 3 practiceUpdated
General education, not financial advice.
- Explain Graham's link between a margin of safety and diversification
- Use the margin of safety to tell investment from speculation
- Calculate how long a large loss takes to recover
The Intelligent Investor: Benjamin Graham's ideas: lesson 22 of 24
- Graham ch. 1
- Investment versus speculation 4 min
- Graham ch. 2
- Inflation and the investor 4 min
- Graham ch. 3
- A century of market history 5 min
- Graham ch. 4
- The defensive investor's portfolio 4 min
- Graham ch. 5
- Defensive investors and stocks 4 min
- Graham ch. 6
- What the enterprising investor avoids 4 min
- Graham ch. 7
- What the enterprising investor does 5 min
- Graham ch. 8
- Mr. Market 5 min
- Living with fluctuations 5 min
- Graham ch. 9
- Investing in funds 5 min
- Graham ch. 10
- The investor and his advisers 4 min
- Graham ch. 11
- Security analysis for the lay investor 4 min
- Graham ch. 12
- Per-share earnings and their traps 4 min
- Graham ch. 13
- Comparing four companies 4 min
- Graham ch. 14
- The defensive investor's screen 4 min
- Graham ch. 15
- The enterprising investor's screen 7 min
- Graham ch. 16
- Convertibles and warrants 6 min
- Graham ch. 17
- Four extreme case histories 7 min
- Graham ch. 18
- Eight pairs of companies 7 min
- Graham ch. 19
- Shareholders, managements and dividends 5 min
- Graham ch. 20
- Margin of safety (1): the idea 5 min
- Margin of safety (2): in practice 7 min
- Graham appendix 1
- The superinvestors of Graham-and-Doddsville 6 min
- Graham postscript
- Graham today 7 min
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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 20, "'Margin of Safety' as the Central Concept of Investment", and Zweig's commentary
What it is
Margin and diversification go together. A margin of safety gives each holding a better chance of profit than of loss, not a certainty. The more such holdings you have, the more certain it becomes that the gains in total will exceed the losses. Graham compares this to insurance.
His roulette example. On a wheel with 38 numbers (1–36, 0 and 00), a 1 dollar bet on one number pays 35 dollars profit if it wins.
- Bet 1 dollar on every number: one wins 35, the other 37 lose 1 each, a certain loss of 2 dollars per spin. The player has a negative margin, and spreading bets only makes the loss more certain.
- If a win paid 39, betting on every number would gain 2 dollars per spin. With a positive margin, the more bets, the surer the profit. That is the casino's position.
Investment versus speculation. Graham proposes the margin of safety as the test. A speculator may believe the odds favour him, but on judgement alone. A true margin of safety is one that can be shown by figures, by persuasive reasoning, and by actual experience.
Price can make an investment. Graham argues that a low enough price can turn a mediocre security into a sound investment, for an informed buyer who diversifies. His example: real-estate bonds sold at par in the 1920s as safe, which in the 1930s fell, in some cases, below 10 cents on the dollar, when the values behind many were four or five times the price.
Quick check
Tap an answer to check it.
On Graham's 38-number wheel paying 35 to 1, what happens if you bet 1 dollar on all 38 numbers?
- One number wins 35, but 37 bets lose 1 each
- You also lose the other 37 bets
Show answer
You lose 2 dollars every spin. 35 − 37 = −2.
Why it matters
Graham's four business principles. He says investment is most intelligent when it is most businesslike:
- Know what you are doing. Don't seek "business profits" from securities unless you know as much about their values as you would about goods you made or sold.
- Don't let anyone else run your business unless you can supervise them properly, or have unusually strong reasons to trust them.
- Do the arithmetic. Avoid ventures with little to gain and much to lose. For the enterprising investor, Graham says, this means operations based on arithmetic, not optimism; for every investor accepting a small return, it means demanding convincing evidence that the principal is not at risk.
- Have the courage of your knowledge. You are right because your facts and reasoning are right, not because the crowd agrees or disagrees.
He adds that the defensive investor need not bring all these qualities to bear, provided they limit their ambition to their capacity and keep to standard, defensive investing. Satisfactory results, he says, are easier to achieve than most people realise; superior results are harder than they look.
Zweig's commentary, quoting the financier J. K. Klingenstein: "Don't lose." A big early loss is very hard to make up. Zweig's example: one investor earns 5% every year; another loses 50% in the first year and then earns 10% a year. The second investor takes more than 16 years to catch up. His other example: someone who bought JDS Uniphase at its 2000 peak and still held it at the end of 2002 would need more than 43 years at 10% a year to break even.
Risk is also in you. Zweig cites the psychologist Daniel Kahneman on two marks of good decisions: well-calibrated confidence (do I understand this as well as I think?) and correctly anticipated regret (how will I react if I'm wrong?). He ends with Peter Bernstein's reading of Pascal's wager: when the future is uncertain, the consequences of being wrong should weigh more than the probabilities. Permanent diversification keeps any one mistake from being a disaster.
Worked example
How long does a loss take to recover? Divide what you need by what you have, then see how many years of growth it takes.
A holding falls by 50%, from 100 to 50. To get back to 100 it must double: a gain of 100%, not 50%.
- At 10% a year: 50 → 55 → 60.5 → 66.6 → 73.2 → 80.5 → 88.6 → 97.4 → 107.2. It passes 100 during the eighth year.
- At 5% a year it would take about 15 years.
The loss in percentage terms is always smaller than the gain needed to undo it.
| Loss | Gain needed to recover |
|---|---|
| 10% | 11% |
| 25% | 33% |
| 50% | 100% |
| 75% | 300% |
Common mistake
Thinking diversification can fix a bad bet. Graham's roulette example shows the reverse: spreading money over many bets with a negative margin only makes the loss more certain. Diversification helps only when each holding has a margin in your favour.
Key terms
- diversification
- spreading money over many holdings so no single one decides the result
- negative margin of safety
- odds or prices set against you, as in a casino game
- speculation
- buying on judgement or hope without a margin of safety shown by figures
- well-calibrated confidence
- being as sure as the evidence justifies, no more
- Pascal's wager
- Bernstein's point that consequences should outweigh probabilities under uncertainty
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| diversification | spreading money over many holdings so no single one decides the result |
| negative margin of safety | odds or prices set against you, as in a casino game |
| speculation | buying on judgement or hope without a margin of safety shown by figures |
| well-calibrated confidence | being as sure as the evidence justifies, no more |
| Pascal's wager | Bernstein's point that consequences should outweigh probabilities under uncertainty |
Practice
Work it through
A holding worth 200 falls by 40%.
- 200 × (1 − 0.40)
- 200 ÷ 120 − 1, × 100
- 120 × 1.10
Quick quiz
Tap an answer to check it.
Why does Graham link a margin of safety with diversification?
- His roulette example shows diversification makes a negative margin worse
Show answer
A margin gives each holding better odds, not certainty; many such holdings make an overall gain much more likely. It is the same logic as insurance underwriting.
What, for Graham, makes something an investment rather than a speculation?
- That is judgement without a demonstrable margin
- Graham says a low enough price can make a lower-quality security an investment, for an informed, diversified buyer
Show answer
A margin of safety that can be shown by figures, reasoning and experience. The test is the demonstrable margin, not the label.
Which question tests "correctly anticipated regret"?
- That tests well-calibrated confidence
Show answer
How will I react if my analysis turns out to be wrong?. Kahneman's two marks of good decisions, as Zweig reports them.
Sort it
Which group does this belong to?
Buying because you expect the market to rise next month
No demonstrable margin, only a viewShow answer
Speculation (Graham's test). No demonstrable margin, only a view
Buying a diversified group of stocks at two-thirds of their appraised value
The margin is shown by figuresShow answer
Investment (Graham's test). The margin is shown by figures
Buying a low-quality bond at par in a boom because it yields a little more
Graham's "fair-weather" purchase, with no real marginShow answer
Speculation (Graham's test). Graham's "fair-weather" purchase, with no real margin
Buying defaulted bonds at a fraction of the value behind them, diversified
His real-estate bond exampleShow answer
Investment (Graham's test). His real-estate bond example
In short
- A margin of safety improves the odds; diversification makes an overall gain more and more likely.
- Graham's test of investment: a margin shown by figures, reasoning and experience.
- A low enough price can make even a mediocre security an investment, for an informed, diversified buyer.
- Four principles: know your business, supervise anyone who runs it, use arithmetic not optimism, have the courage of your knowledge.
- Zweig: avoid big losses (a 50% loss needs a 100% gain to recover).
Mastery check
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Check yourself
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What gain is needed to recover from a 25% loss?
Show answer
About 33% (100 ÷ 75 − 1).
In Graham's roulette example, what would a win need to pay for betting on every number to give a certain profit?
Show answer
More than 37 dollars; at 39, the bettor gains 2 dollars a spin.
Name Kahneman's two marks of good decisions, as Zweig reports them.
Show answer
Well-calibrated confidence and correctly anticipated regret.
Further reading
- Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 20 and its commentary.
- On this site: Investment versus speculation and Margin of safety (1): the idea.
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