For investors, the two major parts of investing that really matter are risk and reward. That’s because investing is all about making money, so risk is how much you could lose and reward is how much you could gain. Sounds simple, but a mistake made by many investors through the years is to think more about one or the other, and this can have a disastrous effect on long term returns.
Fear/Greed
In fact, most investors tend to favour one or the other depending on the level of the stock market and the economic outlook at the time. When things are relatively upbeat, such as at the moment, thoughts are very much focused on potential rewards, with investors thinking about why a company could improve its performance and continue to rise at a rapid rate.
Meanwhile, when stock markets are low and the economic outlook is poor, as they were during the credit crunch in 2009, risk is a bigger consideration and most investors will focus on how much they could lose rather than how much they could gain.
In other words, investors are usually greedy or fearful, with little room in between.
Margin Of Safety
However, the optimum way to balance the emotions of fear and greed that come so naturally to all investors is to focus on a company’s margin of safety. This is a very simple concept that essentially equates the potential for gains and losses in a company’s valuation.
In other words, if the outlook for a company or for its sector is relatively negative and yet the company’s shares are trading on a high valuation, there is a narrow margin of safety. Likewise, if the outlook is positive or neutral and the company has a low valuation, its margin of safety is wide and its shares could be worth buying.
Clearly, there is an element of uncertainty regarding any company’s future, but the idea of focusing on its margin of safety is to assess whether the market is pricing in growth or decline (or something in between). Then, it is possible to unearth undervalued opportunities that could become additions to your portfolio.
Subjective
Of course, how to implement the concept of a margin of safety is highly subjective. In fact, there is no one accepted method — rather, it acts as a useful check on your emotions, which can be unreliable at best.
So, whether you wish to focus on metrics such as price to earnings, price to book or free cash flow, or look at a company’s forecasts or its financial standing, any (or all) of these areas could help you to decide how wide a margin of safety is on offer.
While a margin of safety is very much an intangible thing, it can bring a degree of logic and clarity to the investment decision making process. Although it’s not a guarantee of improved portfolio performance, it should at least provide a sound and logical route to clearer decision making over the long term.