Margin of Safety – Mental Model Explained
Margin of safety is a mental model which will help you gain peace of mind in potentially dangerous endeavors.
If you had to design a bridge that could withstand the weight of 100 cars at any given time,
it would be foolish to design the constraints for just 100 cars.
On a busy day, let’s say Christmas Eve, the bridge could have 160 cars trying to link up with their families for the holiday.
The bridge will likely collapse, and you would have a big lawsuit coming your way – probably some jail time as well.
Luckily, engineers learned to avoid this folly many years ago.
Even the ancient Romans would design their structures to withstand more than the normal operating capacity.
To avoid catastrophe, you don’t design the bridge for 100 cars but instead 500 (factor of safety of 5).
This preventive mental model can be used in all areas of life.
It’s what your father meant when he said to
‘Measure twice cut once.’
You need some wiggle room to avoid troubles.
Margin of Safety Mental Model Examples
How To Use Margin of Safety in Real Life?
The margin of safety mental model can be easily used in real life.
First consider the things which are important to you, see where you could be multiplying by zero, and design buffers to help cushion potential blows.
You have a job, and you fear possible layoffs due to the changing economy. You can employ a margin of safety through applying for a second job or developing another form of income independent of your job (such as a side hustle). You could even begin saving a little more money to avoid having the rug swept from under you. The idea of an emergency savings fund is a good example of margin-of-safety mental model thinking.
Instead of waiting for an organ to stop working before you go see the doctor, you could schedule tests to be done (such as blood tests and general checkups). These could be undertaken once a year or every 6 months depending on how preventive you want to be. This won’t stop you from dying but can help you catch things before they develop leading to a better quality of life.
Using the safety bars on the squat rack, having a spotter on the bench press, and wearing wraps before lifting heavy are all margin of safety initiatives. There have been documented cases of people dying in the gym just from not using these simple solutions. These methods heavily decrease the chances of injury, allowing you to lift weights into your old age.
We have all slept through an alarm and missed an important event. This can be easily fixed by having 2 or 3 alarms set the night before. A bigger margin of safety can be created by having alarms on different devices (in case one doesn’t work). You can even have notifications which go off the night before to remind you of your commitments.
Many cars have various safety features which provide a margin of safety. Having a spare tire being an easy example. You can increase the margin of safety by having 2 spare tires. Owning the appropriate tools to change a tire such as a jack and wrench is important. There are other useful features which can be helpful whilst driving such as a rearview and dash cam. Each of these small additions helps create a larger margin of safety when driving.
Margin of Safety in Business
Businesses can have a large margin of safety by contesting in blue oceans instead of red. Red oceans breed destructive competition whilst blue oceans are a haven from the chaos.
Products and services which have been commoditized tend to reside in red oceans. It’s hard to gain a unique selling proposition (USP) when you are selling matchsticks. It’s easier to differentiate yourself when you sell Teslas.
Unicorn businesses are one of a kind and hence avoid competition altogether. A good book on the topic is ‘The Blue Ocean Strategy’.
We like businesses that are protected in some way from competition.” – Warren Buffet
There are many podcasters in the world, but no one can replace Joe Rogan. Through his unique set of characteristics and diverse interests he has created a blue ocean for his business. Companies competing in red oceans, such as Coke, need to develop a strong brand to have a margin of safety. The Coke brand has been around for over 100 years and occupies the minds of millions of consumers. This is not easily reversible. (Learn more about this in ‘The 22 Immutable Laws of Marketing’).
You can increase the margin of safety of a business by increasing its streams of income. A business with one stream of income is incredibly volatile as a change in consumer interest could lead to bankruptcy.
Businesses that thrive create a range of successful products and services. They focus on developing strong referral networks and strategic partnerships with other businesses.
In business, I look for economic castles protected by unbreachable ‘moats’.” – Warren Buffet
Entrepreneurs must see their business as a citadel surrounded by a moat. The moat is to keep the barbarians out. Each income stream helps deepen the moat and protect the asset.
Cashflow is king and can help solve most problems a business will encounter.
A good example of a business with a strong moat is Amazon.
For years Amazon focused on books.
Once they established themselves in the book market they moved to CDs and DVDs.
In time they sold millions of different physical products.
Now they have moved to digital streaming, competing with the likes of Netflix and Spotify for eyeballs and ears.
Amazon developed its affiliate and referral programs many years ago and has enjoyed explosive growth due to the network effect and positive feedback loops.
Amazon has also acquired a range of companies such as Audible for $300 million and over 40 other subsidiaries.
Each acquisition building a deeper moat.
When you look at the most valuable companies in the world such as Apple, you will see they have all followed similar strategies.
Margin of Safety in Investing
Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety.” – Benjamin Graham
The Benjamin Graham method of investing – much loved by Warren Buffet and Charlie Munger – is a form of value investing.
The idea being to estimate the intrinsic value of a stock through a range of calculations and analysis of various factors.
The intrinsic value might be different to the market value.
So, you look for massively undervalued stocks and purchase them with a factor of safety.
For example, let’s say the stock of Company A is at $80.
You calculate the intrinsic value of Company A to be $82. This would not be a sound investment as the margin of safety is too low.
If Company B is trading at $80 but you estimate its intrinsic value to be $120, this would be a good investment based on your intrinsic value offering a 33% margin of safety.
Here is the margin of safety formula:
Margin of safety = 1 – [Current Stock Price] divided by [Intrinsic Stock Price]
We got the above result with:
1-(60/120) = 0.333 which as a percentage is 33%.
The margin of safety approach requires patience as you will be waiting to buy stocks at a discount.
It’s not foolproof as your estimates could be wrong, but the idea is to minimize the downside by only purchasing things which are largely undervalued.
The bigger the margin of safety, the more likely you are to protect your money.
Margin of Safety Mental Model Checklist
Below are a few questions which will help you get the most out of the mental model.
Question One: Can I calculate my margin of safety quantitatively?
In some instances, you can calculate your margin of safety with equations. Engineers, business owners and stock traders can calculate the factor of safety using simple formulas.
If the answer is no, skip to question three. If yes, go to question two.
Question Two: What numerical range can I allow for the margin of safety?
If you are a trader or business owner, this range is based on your risk tolerance. If you are an engineer, it’s based on the engineering standards of your country. It’s important to have a range and stick to it. Perhaps in stock trading you will not invest in any stock which doesn’t have a margin of safety of at least 30%.
Question Three: What qualitative measures can be taken to increase my margin of safety?
Not every factor which increases your margin of safety can be calculated. Some things you just know intuitively. There is no way to know how much margin of safety a spare tire can provide for your holiday trip, but that shouldn’t stop you from getting one. Think of anything which might help increase your level of safety. An engineer can have someone check the condition of the bridge every 3 months to see if there are any structural defects. A trader can show the stock to a trusted advisor for a second’s opinion.
Question Four: Check your premises
Recheck your estimations and justifications. This mental model is useless if it’s built upon a foundation of sand. An error in a calculation or false assumption can undo all your hard work, so it’s important to be diligent in this step. A spare tire won’t help if your car is in desperate need of an oil change. The margin of safety of the car travelling on top of the bridge won’t matter if you didn’t account for the earthquakes which affect it from below.
The margin of safety mental model is a powerful tool to add to your latticework of mental models.
Use it and you will be one step closer to living and dying well.