What Does a Margin of Safety Mean for My Investments?

thinking about a margin of safetyWise investment advisors often talk about having a margin of safety as part of their financial strategy. But what exactly does that mean?

It’s a difficult concept to explain. However, by doing your due diligence before making investment decisions you can have some assurance of safety if the future brings an unpleasant surprise.

For those who like technical definitions, The Motley Fool has an article defining Margin of Safety.

Now, remember there’s no such thing as a risk free investment. Fortunately, by applying trusted methodology to your investment decisions you can ensure that margin of safety and avoid the dangers of speculation.

What are Some of those Trusted Methodologies?

To get a better return on your money you must assume some risk. There are safe ways to achieve this goal:

  • Solid companies with a long track record of earnings are a good place to begin. Though any company can suffer a setback you want a margin of safety against the business never being able to recover or worse go bankrupt. We call these businesses blue chip stocks.
  • Any sensible portfolio will have a bond component, typically between 20 to 40 percent. Bonds are unique in that they have a built in margin of safety based on the yield, ensuring earnings over time. The price you pay for that safety is a lower expected return on your investment.
  • Diversification is the ultimate margin of safety. By owning a fund that invests in the top companies on the stock markets in North America plus international stocks combined with a bond component you have the best chance for success with the least exposure to loss. Diversification allows you to spread the risk over many assets. This reduces the possibility of owning the wrong asset at the worst possible time.

“Where the Experts Say to Invest Your Money Now” is an interesting article you may wish to read.

Margin of Safety in Other Financial Decisions

mortgage loanMargin of safety also applies to other financial decisions. Take mortgages as a prime example. As many people are now unfortunately finding out, your monthly mortgage payment must have a margin of safety against potential future interest rates.

When rates rise you will eventually have to renegotiate your mortgage meaning higher monthly payments. Without a margin of safety many will be unable to afford that higher rate and be forced to sell or accept a longer amortization period.

Emergency Fund as a Margin of Safety

An emergency fund is by definition a built in margin of safety against the unexpected. Far too many people deny that a job loss, downsizing, illness or injury can drastically affect their income. It can and does happen.

Don’t forget to take advantage of Free Money.

Be a Wise Investor

Wise investors build a margin of safety into every financial decision they make. This ensures a cushion against the inevitable misfortunes that regularly occur in our lives. This helps prevent you from making speculative investments that can destroy your wealth.

I have devised a simple plan for my investments which I share in “Investing Made as easy as One Two Three.”

Water BarrelThe BalanceIn my E-books (“Water Barrel” and “The Balance”) I discuss simple methods to live sensibly for today, take charge of your financial affairs, and invest safely for the long term. For more information please visit David Penna Amazon.

As always, I am not a qualified financial advisor. I just relate financial management to my own experience which may not resemble yours at all. Advice is frequently worth exactly what you paid for it. Most of mine came from expensive experiences.

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