In a recent post on the Financial Planning Association’s blog, Joe Pitzl, CFP®, Director of Financial Planning at Intelligent Financial Strategies, LLC explains the “Margin of Saftey” Concept applied to financial planning.
I’ll include a summary here, as the issue is key to successful financial planning today.
With respect to its origins in investing, a basic description of the margin of safety principle is that it implies that there is a favorable difference between the price paid for an investment and its actual value –- a buffer.
Virtually any time Warren Buffett is asked how investors can become better investors, he refers them to Chapter 20 in The Intelligent Investor (Benjamin Graham), aptly titled: “Margin of Safety” as the Central Concept of Investment.
As investments get hyped and their valuations inflate, the margin of safety concept tends to be forgotten. But as Pitzl illustrates, a successful investment not only involves identifying the right investment, but also getting the right price. And buying at fair value isn’t enough to assure success -- you need to have a buffer.
In recent years, many people failed to consider the margin of safety concept in both investments and personal finances. We bought houses we couldn’t afford, refinanced those mortgages at inflated pries, and stopped saving. We failed to plan for the “what ifs”.
“Many people were caught sitting far out on an extended tree limb and had no chance of hanging on against the storm that quickly formed on the horizon,” writes Pitzl
In his book, Graham points out that the importance of the margin of safety has far less to do with maximizing return and far more to do with insulating oneself against the effects of a miscalculation, or more likely, incorrect assumptions.
By always insisting on a margin of safety when creating your clients’ financial plans, you may have to tell clients to cut expenses or work longer, but you’ll be helping them get down from that tree limb before the next storm arrives.
“As true as it is when investing, it is far better to be approximately right than precisely wrong in your financial planning decisions as well.”
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