“Risk comes from not knowing what you are doing”, said Warren Buffett.
I totally agree with Mr. Buffett on this.
Taking risk just for the sake of taking risk is a bad idea, rather it is stupidity.
Also Know: How “risky” is risk?
In your both personal and professional life, you should take some amount of precaution to minimize the effects of risk.
In Investing, in order to protect your portfolio from wild fluctuations in the market, you should always opt for “margin of safety”.
“Margin of safety” as the name suggests, is a process of buying securities at a deep discount from the underlying value and holding the securities until more value is realized.
In a nutshell, it involves buying securities at a bargain price.
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It also provides a cushion to the investors against any loss which they might undergo on account of bad luck, human error, wild volatility etc.
Moreover, it is also important for two reasons since future cannot be predicted and there is a high possibility for an investor to commit a mistake.
Warren Buffett shares his own experience with regards to the margin of safety in his letter to the shareholder. He said-
SAFECO is a much better insurance operation than our own, is better than one we could develop and, similarly, is far better than any in which we might negotiate purchase of a controlling interest.
Yes our purchase of SAFECO was made at substantially under book value.
We paid less than 100 cents on the dollar for the best company in the business, when far more than 100 cents on the dollar is being paid for mediocre companies in corporate transactions.
And there is no way to start a new operation- with necessarily uncertain prospects- at less than 100 cents on the dollar
Know More: Top 5 investing lessons from Warren Buffett’s shareholder’s letters 2016
Benjamin Graham (father of value investing) believes that in order to judge the earnings power of a company, we should not only check the recent 1-2 years performance but also how the company performed during the poor times.
Graham said-
“Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of price paid.
This figure is sufficient to provide a very real margin of safety which under favourable conditions, will prevent or minimize a loss”
Correlation between the margin of safety and theory of diversification
Margin of safety and correlation have a very close connection.
A stock may work out badly, even though the margin of safety is in favour of an investor.
There should be an adequate diversification benefit in your stock portfolio since even complete margin of safety cannot assure profit for an individual stock.
Read More: Portfolio Diversification Simplified
Diversification involves buying stocks of more than one company and reducing the risk from an individual stock.
Bottomline:
To end up, I would like to leave you with a lovely quote by Benjamin Graham. He said-
There is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks.
Even the best company becomes a ‘sell’ when its stock price goes too high, while the worst company is worth buying if its stock goes low enough
Happy learning!!
