The margin of safety is a concept that can prove useful for investors. In short, it is the difference between an investment’s intrinsic value and that same investment’s purchase price, meaning that a bigger margin makes for a safer investment. With that said, there is no such thing as a perfect investing method, so it should come as no surprise to learn that there are some things that interested individuals should keep in mind when using it.
What Are the Potential Issues with Margin of Safety?
Investments can both rise and fall in price. However, when there is a bigger margin, that means that the investment has to fall further before it becomes a loss. In turn, this means that this should have a smaller chance of happening under normal circumstances. As a result, while a bigger margin won’t provide interested individuals with perfect protection for their investments, it should nonetheless be much better than nothing at all.
With that said, interested individuals can’t make good use of the margin of safety unless they are capable of estimating the intrinsic value of potential investments with some measure of accuracy. Unfortunately, this is much easier said than done, not least because the very concept of intrinsic value can be rather nebulous.
In short, the intrinsic value is the value that an investment is supposed to have based on a fundamental analysis of both quantitative and qualitative factors. As a result, it is not the same thing as that same investment’s market value, which can be influenced to a significant extent by investment sentiment as well as other factors with no connection to the fundamentals whatsoever. There are entire philosophical debates that can be had about whether intrinsic value should even be considered a thing or not, but the relevant part is that no one has ever managed to come up with an indisputable way to calculate intrinsic value for any field. Never mind such a method for investing in particular.
Of course, that hasn’t stopped interested individuals from coming up with various ways to come up with estimates for intrinsic value. One common example would be the present value of the investment, which means calculating the present value for its expected cash flows before coming those results to produce a rough estimate. Unfortunately, while the calculations are simple and straightforward so long as interested individuals have the relevant numbers to plug into the right formulas, there is still the issue of coming up with those numbers. In some cases, interested individuals can fall back on historical precedence; in other cases, well, suffice to say that estimating those numbers can be very challenging exercises in their own right.
Regardless, the fundamental issue with the margin of safety should be clear. It is useful, but it is only useful if interested individuals can actually make good estimates of an investment’s intrinsic value. Even worse, if someone can’t make good estimates but believe that they can, that can actually make their analysis worse by convincing them to put their faith in unreliable numbers. Something that comes with a lot of potential pitfalls.
How Is Margin of Safety Relevant for Real Estate Investors?
For real estate investors, having a margin of safety can help them minimize the risk of their investments. However, it is important to note that there is no such thing as a right margin because each person has their own level of risk tolerance. As a result, a margin that works fine for one person might not work fine for another person because the second individual might be willing to take on either more or less risk in exchange for the potential of either more or less reward.
With that said, real estate investors who want to use the margin of safety might want to start preparing themselves to make better use of it. In part, this means that they should read up on real estate valuation, which should combine with their real estate experience over time to coalesce into the ability to estimate the intrinsic value of real estate properties based on a wide range of information. However, they should also be seeking out real estate professionals whose expertise and experience they can trust, who can provide them with further insight to help them shape their decision-making. Finally, interested individuals will want to learn to monitor the real estate market for good opportunities to come along because there will be a lot of other real estate investors who want exactly the same thing that they do, meaning that such opportunities will be short-lived.