What about the margin of safety?

There are just a handful of things thing that I remember out of the several finance classes that I attended during MBA.

In those days, we had a great professor teaching us derivatives and investments – Kshama Fernandes. In one of her classes, she said that “a lot of students come to me and ask about stock returns. They want to know how much a stock can return over a year, what are the best financial models to calculate expected returns etc. But so far, not a single student has come to me and has asked about risk”.

I don’t remember what went on in the rest of the class or what she taught about risk. Partly because I was upset as having missed the chance of being her first student who asked about risk and partly because around that time I was first introduced to Benjamin Graham’s “Margin of Safety” concept.

It seemed that he was saying, first look at how much  you can lose in the worst scenario and then go from there.

Basically Margin of Safety is a principle propounded by Graham and Dodd in their book Security Analysis and it is a central idea of value investing.

It looks at discovering stocks that have been neglected  by the stock market and are trading at a price that is much lower than their intrinsic value. Once you find such stocks, you should look at how much margin of safety you have. So if the stock is trading at half its intrinsic value, then your margin of safety is higher than, if it were trading at 90% of its intrinsic value.

If you read that carefully, you will realize that one of the important tenets of this principle is how much money can I lose? Only if you are certain you can’t lose more than you are comfortable with, you should go ahead and calculate returns and see how much you can make on that stock.

So you go from risk to return and not just talk about return.

This is a fascinating concept and one, that is easy to understand and difficult to follow. What principles do you follow while selecting a stock?

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