Margin Of Safety: A Different Perspective On Risk

The margin of safety refers to the buffer or cushion between the optimal state of a system and a point at which it risks failure or collapse. Originally it is an engineering concept, though it has leaked into investing and can be applied to nearly every area of life. The term describes deliberately leaving a protective gap to account for uncertainty, variability, and error. Essentially a room for failure to guarantee success—or atleast stymie complete catastrophe—in the face of unforeseen challenges.

Life and systems are inherently uncertain. A margin of safety compensates for these unknowns, such as buying a stock when you know it is below it’s intrinsic value to account for the risk of misestimating the value. The margin reduces your exposure to catastrophic failure. It’s about striking a balance between planning for the worst while striving for the best. Bridges, for instance, are made to hold significantly more weight than their expected load and this makes them reliable even under extremely volatile situations—like needing to evacuate a city or handle a local football game all of a sudden.

Deliberately being cautious with your estimations buffers those instances—even if those instances are rare—where you are wrong. Financial analysts assume lower-than-expected returns on their investments when calculating whether it is safe enough for this reason. You don’t want to operate at the limit of capacity, as any unexpected shift will cause your breakdown. The same applies to systems with changing conditions. One you are part of and use daily: your calendar. Building in downtime is a wise decision to not run late and be ready when emergencies arise.

What’s more, operating with a margin of safety allows you to experiment at zero or greatly reduced risk. An entrepreneur can, for example, launch a beta version of his product to test and refine it, to see whether users like it, before investing into full-scale development. The margin between being fully vested and remaining in the safe zone lets you learn without jeopardizing overall stability. Value investors like Benjamin Graham and Warren Buffet use the principle extensively. They only buy when there is a significant gap between the money they vest and the value they expect, protecting themselves against market volatility while growing capital.

The margin protects investors from poor decisions as it protects engineers’ bridges from collapse. Warren Buffet analogized: “You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.”

View the margin of safety as the “reserve” of load that can be placed on a system before it fails. You always want to operate while leaving something on the table. That’s your “reserve”, your “just in case”. How much safety you want depends on the possible consequences. To exemplify, engineers rely on pretty strict standards using the imposed loads, strength of structures, wear and tear estimates, and the environment to which the product will be exposed to in service. For buildings, the safety factor is commonly 2—or twice the anticipated maximal load before collapse—for each structural component. Automobiles use 3, and aircraft and spacecraft use between 1.2-4 because a higher number would make the craft too heavy to lift off the ground.

Aerospace engineering safety margins bring us to an important point. Margins of safety are good, but sometimes you want risk. Risk is not always bad. If you tried to eliminate all risk whatsoever, you wouldn’t be using technologies like smartphones—or even lighting fires for that matter, we’d still be in the caves. A certain amount of risk must still be taken. You can only leave so much on the table—though you do need to leave a little. For instance, you do not want to train in the gym with such a margin of safety that you fail to put on any lean tissue—such as by training with a lot of reps in the tank on every set. Accordingly, you do not want to operate at your limit as that puts you at risk of injury—such as by training and reaching complete failure on every set. You want to be somewhere in the middle, enough to progress whilst not so much to regress.

Real life implications of margin of safety:

• Engineering: designing airplanes, buildings, automobiles, and bridges requires engineers to take safety factors into account; hence a bridge rated for 20 tons might be able to withstand 200, though you do not want to find out;

• Finance: maintaining an emergency fund and balance for a rainy day, whilst investing with diversification in mind can ensure financial stability during uncertain situations while growing capital simultaneously;

• Project: estimating slightly more time and resources than a project initially appears to require can account for unexpected delays and issues which we all hate;

• Fitness: as a trainer of any level you have to account for recovery time and situate a margin between training intensity and injury risk by training below your maximal capacity; as they say: “Listen to your body”;

• Time: if you’re a victim of chronic lateness or just want to always be on time it’s a great idea to employ a margin of safety into your schedule by allocating slightly extra time for meetings, breaks, and tasks to prevent your schedule from being derailed by fluctuations;

• Technology: ensure your systems are designed with redundancy to avoid singular points of failure that make for systemic downtime by building in fail-safes and conducting stress-tests, taking into account edge-cases like spikes in users;

• Decision-making: factor in a margin of safety when making any significant choice, like a major purchase or career change, so as to reduce the risk of negative outcomes—inversion works in perfect combination here;

• General: all of the aforementioned serve the same function and you can apply margin of safety to your relevant field; the aim: flexibility, reliability, and mitigating potential risks while maximizing gains.

How you might use margin of safety as a mental model: (1) assess the risks, identifying potential failure points and uncertainties in your current systems and practices—what could disrupt your investment, project, habits, or health plans; (2) establish the buffer, creating a conservative cushion that accounts for the risks you assessed, overestimating required resources—time, effort, and money—while underestimating potential returns; (3) prioritize resilience, building margins of safety into every single one of your high-priority systems for them to be able to withstand stress; (4) prepare for the worst-case scenario in your plans and processes, ensuring that even if you fail short-term, you win long-term; (5) iterate and refine your margins when conditions change—such as the strength of your exercise habit when you move.

Thought-provoking insights. “Hope for the best, prepare for the worst.” highlights the importance of readiness in the face of uncertainty. “Better to be safe than sorry.” a classic proverb emphasizing the need for caution and planning. “A chain is as strong as it’s weakest link.” stresses the importance of accounting for vulnerabilities when planning—also part of a priceless mental model, multiplying by zero. “Don’t put all your eggs in one basket.” reminds us to diversify in order to create a margin of safety in whatever we are doing, be it investing or lifting weights.

Questions to reflect on:

1. How can you apply the margin of safety to your decision-making process to safeguard against possible risks?

2. In what ways does a buffer, be it financial or relational, help mitigate the impact of unanticipated challenges?

3. When has a well-situated margin of safety helped you recover in the face of setbacks?

4. How did an overly conservative margin of safety hinder potential growth for you in the past?

5. In what scenarios could a margin of safety be integrated to encourage innovation while handling risks?

Quotes to scratch your brains:

1. "The margin of safety is the secret of sound investment." - Benjamin Graham.

2. "A little cushion goes a long way in protecting against the harshest blows." - Unknown author.

3. "Safety doesn't happen by accident." - Unknown author.

Example use cases:

1. Investments: allocating extra capital acts as an investing buffer, ensuring that even if market conditions worsen, the downside is limited.

2. Project: building in additional time and resources to project timelines help cushion you against delays and unforeseen issues that can otherwise derail overall progress.

3. Product: incorporating safety factors into the engineering of a product so that it performs reliably even under unanticipated stress or usage conditions.

4. Business: maintaining reserve funds or liquidity helps navigate unanticipated economic downturns and expenditures.