29 March 2011

Margin of safety - first thing in the investment world

The definition of investment to me is you are utilizing current resources on the hope of achieving greater returns. You must be very sure that the investment is positive return before you invest in it. However there are some descipline you must follow, and margin of safety is the first principle you must remember.

Margin of safety by definition is to set aside a buffer of the target return which you would like to achieve. It was first introduced by Benjamin Graham. For example, if the intrinsic value after you calculation is $1.00, the investment guru advised us to purchase at $0.70 or 30% lower. This 30% is set as margin of safety.

The benefit of margin of safety includes:

1. As intrinsic value is always an estimated value based on current facts and subjective opinion from investor, we can avoid or reduce the possible downside when intrinsic value turns up to be much lower than what we expected. As a result of it, we can pay little for the potential losses.

2. As market is always rational, however there are sometime market react overly to the negative or positive event. If the prices drop below sharply against the intrinsic value, it is
a great chance for us to earn more as compared to the time when nothing happens in the market.

3. It can train us to be patient as there is seldom chance of having a lot of good opportunities. Because we can invest in lower prices, we are in more confidence to hold it for a longer period and thus achieve a better results.

Nonetheless, we have to bear in mind that margin of safety is just part of the investment principles and there are still many principles we need to follow.

Related posts:

- Behaviour of Business Like Investor
- Cash Flow - Blood of your Investment Journey

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