Benjamin Graham was an American investor and economist. Born in the UK in 1894, he warns that no investor can ever eliminate the risk of being wrong.
They may, however, insist on never overpaying, no matter how exciting the investment. He called on investors to use a margin of safety.
It is essentially the difference between the cost of an investment and its intrinsic or natural value.
Think of a safety margin like a seat belt.
Ideally, you’ll never need to put it to the test, but having a safety margin in place helps prevent potential misfortunes and even disasters. It also allows for vagueness and mitigates bad luck.
How Warren Buffet made millions with a margin of safety
Benjamin Graham died in 1976, but Warren Buffet cites him as a key influence. In a reminiscence for Graham, Buffet wrote,
[Graham’s] the advice of solidity brought sure rewards to its followers – even those with natural abilities inferior to more gifted practitioners who stumbled upon following brilliant or fashionable advice.
Investors like Buffet worry about risk. They don’t want to lose all their money on a single or risky investment. When evaluating a business or an investment, Buffet always applies a margin of safety.
For example, in the spring of 2002, Buffet read PetroChina’s annual report. He determined that the Chinese oil and gas company was worth $100 billion. The company was selling for $35 billion.
Buffet calculated a margin of safety of $65 billion, so he bought PetroChina for $488 million and sold it in 2007 for a profit of $4 billion.
Manage risks in the real world
Of course, not all of us are budding Warren Buffets, but successful professionals always apply a margin of safety to their work.
Similarly, engineers design bridges to support more weight than is allowed on the bridge itself. They also design tall buildings and skyscrapers that sway in wind currents and turbulence without collapsing.
The Eiffel Tower, for example, sways up to 13 centimeters in the wind, much to the chagrin of many new visitors.
How to apply a safety margin to your work
You can apply this mental model to many real-life situations. The trick is to stay away from activities where you have little to gain and everything to lose.
If you run a small online business, keep two or three months of cash reserves in your bank account. That way, if you face an unexpected expense or a drop in income, you’ll still be able to pay your bills.
If you invest all of your cash flow in Facebook ads, how will you pay web hosting or your email service provider if those expensive ad leads don’t convert?
If you’re a busy corporate executive, commit to your boss and team to deliver a key project by a certain date.
You don’t have much to gain from working on this project until the delivery date. Instead, push yourself to finish it early. This way you have a margin of safety in case the unexpected happens.
Master your inner game
It doesn’t matter if you are an investor, a founder or an executive; you will always be faced with factors beyond your control.
The market could go up or down, your editor could cut their budget for freelancers, or it could rain heavily on race day.
Take Courage by Benjamin Graham.
He wrote that “investing is not about beating others at their game. It is about controlling yourself at your own game.”
Whether you’re an investor, athlete, or artist, you can always control your inner game.
Develop more than one revenue stream for your business.
Calculate what is at risk and the cost before investing time, energy or money in a project. Always pay less than you think something is worth.
Be realistic about your expectations for the future rather than indulging in idle fantasies.