Margin of Safety

Margin of Safety

The principle of margin of safety comes from the discipline of engineering but was adopted by those in the finance industry as a way to minimise risk.

The concept was made famous by Ben Graham most notably in his book the Intelligent Investor and subsequently by his followers, namely Warren Buffett. It is also mentioned by Jesse Livermore in his book Reminiscences of a Stock Operator.

It is a very simple concept that helps you absorb errors and bad luck with a view of minimising losses.

Margin of Safety Bridge Analogy

The concept of margin of safety is best explained with a bridge analogy. Let’s say a bridge is required to support a weight of 100,000 kg worth of weight at any given time. Engineers would build the bridge to support a weight much greater than expected to give themselves a margin of safety. It is entirely possible a fleet of trucks all carrying heavy loads get stuck in traffic on the bridge at the same time. The bridge needs to be built with a significant room for error to take into account any unforeseen circumstances.

Get the Best Price You Can

Trading should be approached with a similar mentality. The trades you place should be at a price significantly above or below where you think a price will go, you want the greatest room for error. The higher the margin of safety the lower the risk you take. A high margin of safety doesn’t guarantee a winning trade but generally provides more room for error and bad luck.

You don’t always need to pay up into the offer or down into the bid. The majority of the time you can work for a better price and get it. Paying into the market is a very common reason that retail traders under perform, they are too eager to get on the trade. When you get a better price you get a better risk reward trade and hence have a higher win rate.

Strive to get the best prices.

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