Investors often wonder--How do I make my investments less risky? Is there a formula for it?
Well, you can use the margin of safety to minimize the risks of losing. This is a concept used by many existing investors and it’s basically a strategy to determine whether a stock is worth buying or not. The margin of safety is determined by the market value of the stock minus its intrinsic worth.
To know more about how it can help you become a better investor, here are some essential points to consider.
The margin of Safety is a concept of investment in which an investor buys securities only if their market price is considerably below their intrinsic value. In other words, if the price of a securities market is much below your estimate of its intrinsic worth, the safety margin is the difference. Since investors may select a safety margin according to their own risk choices, the purchase of assets where this difference exists permits investments with minimum downside risk.
Otherwise, the security margin or safety margin refers to the gap between sales value and break-even sales in accounting. Managers may use the safety margin to assess how much sales may decline before a firm or project is unprofitable.
The notion of margin of safety was made popular by the famous American British-born investor Benjamin Graham and his supporters, most prominently Warren Buffett. Investors use both qualitative and quantitative elements to assess the intrinsic worth of securities, such as corporate management, management, industry performance, assets, and profits. The price of the market is then utilized to compute the safety margin. Buffett, who is a firm believer in the safety margin and claimed it to be one of his "cornerstones of investment," has been known to impose as a price objective a 50% discount on the stock's intrinsic value.
Considering an investment safety margin offers a coating against mistakes in the analyzer's judgment or computation. However, it does not guarantee successful investment, mainly because it is very subjective to determine the "real" value or intrinsic value of a firm. Investors and experts may have an intrinsic value calculation technique and are seldom accurate and correct. Moreover, it is infamously difficult to anticipate the income or revenue of a corporation.
A crucial element of value investing is to guarantee that your assets have a safety buffer.
What this implies is that you acquire an inventory when its value is not only lower or equal to your fair price, but also substantially lower. This gives you a gray area where your predictions on the firm may be a little incorrect and yet the investment is OK in the long term.
The safety margin suggests that your assumptions should be well placed to avoid this investment. However, even then, the situation becomes statistical by diversification among 20+ firms and different asset classes. For instance, if you invest in 20 firms and invest only when a stock trades at least 15% under the fair price computed, one or two of them will go wrong but your total portfolio will continue to operate brilliantly.
To purchase at an undervalued cost, you must first know whatever the fair price is. This brings together art and science. The concept is that you can quickly compute the objective fair value of any firm or asset that creates cash flow by use of flawless company estimates and your goal rate of return.
The trick is, obviously, that you have no precise estimations, you have just your imperfect guesses. You may estimate based on previous rates of growth, or on emerging developments that might influence those rates, by analyzing the way the firm spends its money, or by using credible management plans and a habit of achieving these expectations.
Calculating the intrinsic value of your investment
The amount of the security margin varies according to investor preferences and the kind of investment it makes. Basically, investors can use margin of safety in two different strategies: deep value investing and dividend growth investing.
"Deep Value Investing" refers to the purchase of stocks in underestimated companies. The objective is to identify substantial differences between the present stock prices and their intrinsic value. These firms are, because of the degree of disparity, frequently tiny or in terrible form. If they were well-known and in good shape, there would be no serious price and value discrepancy, except for the macroeconomic deepening of the local market in early 2009.
Deep value investment thus demands goods. You have to choose the debris and locate value where others don't perceive it. You have to see data other people don't see, or you have to understand and act on information other people have, but misinterpret or don't. Of course, a deep value investment demands a significant amount of security to invest with and is not for most casual traders.
"Dividend Growth Investing" means a more balanced approach. With this investment approach, you choose firms that have favorable rates of growth that are also considerably lower than your estimation of fair value. Cultivated investment is closer to GARP investment than deep-value investment because investment in dividend growth relies on choosing firms with wide moats, solid balance sheets, the opportunity to grow dividend payments through recessions, and a service or product which you can see now, which is 10 or 20 years old and indeed prosperous.
With Dividend Growth Investing or GARP investing, it's necessary to have a 10 percent security buffer, but it doesn't take long for you to identify big price/value discrepancies that enable you to purchase with a significant safety margin. The choices are more consistent and less contrary. You are thus just investing with a varying time horizon rather than investing in access to superior knowledge or interpretations than others. While others may be concerned with a quarterly report or a congressional report or a job report, in the next five to ten years you are concentrating on your residual income objectives.