From Shane Parrish’s book “Clear Thinking”
Why do you need margin of safety?
- “You don’t always need to have the ultimate solution to make progress. If it remains unclear which path is best, often the next best step is just to eliminate paths that lead to outcomes you don’t want. Avoiding the worst outcomes maintains optionality and keeps you moving forward.”
- “Sometimes things fail for reasons beyond our control. A lot of tricky and highly consequential decisions, though, fail for preventable reasons. When we don’t consider how things might go wrong and plan for them in advance, we’re left flat-footed when they do go wrong. Then we end up reacting instead of reasoning. It’s much easier to plan for things that could go wrong in advance when you’re calm and open-minded than it is to respond when things are in the midst of going wrong. When failure is expensive, it’s worth investing in large margins of safety.” (p. 193)
- “A margin of safety is like having insurance. If you know in advance you won’t need to make a claim this year, it’s a waste of money to buy insurance. The problem is that you don’t know in what year you’ll need to make a claim, so you buy it every year. It might seem like a waste of money in years when nothing happens, but it shows its real value in years when something does.”
- “Building a margin of safety means giving yourself as much cushioning and coverage in the future as possible. It’s a way of preparing yourself for the widest range of possible future outcomes—and protecting yourself against the worst ones.” (p. 195)
- “Warren Buffett has a saying that I often come back to: “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” The thing is, most of us rarely know what we are doing with the confidence required to go all in. When you don’t know what you are doing, a margin of safety saves you from the worst outcomes. Even when you do know what you’re doing and you make the best possible decision at the time, things can change.”
- “If the worst-case outcomes never come to pass, the margin of safety will appear like a waste. The minute you convince yourself you could have done better without a margin of safety is exactly when you need it most.”
What are some things that you need margin of safety?
- We can’t prepare for everything. Some horrific events defy imagination, and no amount of preparation can ever give you enough optionality to deal with them. Yet we know from history that there are certain unfortunate events that we’re guaranteed to experience and that we can in fact prepare for, even if we have no idea when they’ll arrive. On a personal level, these include:
- Grief from losing a loved one
- Health issues
- Relationship changes
- Financial pressures
- Challenges in meeting our career goals
- On a more macro level, they include the following:
- War and political dissent
- Natural disasters
- Environmental and ecological changes
- Economic fluctuations: both collapse and growth
- Technological advances and resistance to them
How do you build a margin of safety?
- How do you build a margin of safety? Let’s start with a very typical application. Engineers build margins of safety into everything they design. Suppose, for instance, that we’re designing a bridge and calculate that on an average day it will need to support 5,000 tons at any one time.
If we build it to withstand 5,001 tons, we have no margin of safety: What if there’s heavier traffic than usual one day? What if our calculations and estimates are a little off? What if the material weakens over time at a rate faster than we imagined?
To account for all of these contingencies, we’d need to design the bridge to withstand 10,000 or even 20,000 tons. Why? Because we don’t know what the future will bring. We don’t know whether multiple trucks will ever get stuck on the bridge at the same time. We don’t know whether vehicles in the future will be much heavier than they are now. We don’t know many things about the future. So we design the bridge in a way that protects travelers in the widest range of possible future outcomes.” - Keep in mind as you’re preparing for the future that the worst outcomes in history have always surprised people at the time. You can’t use the historical worst case as your baseline. Engineers don’t rely just on the historical use of current bridges. You have to really stretch your imagination to explore and anticipate what could potentially go wrong.”
What are some rule of thumbs for margin of safety?
Here’s a simple heuristic for creating a margin of safety so you know when “enough is enough.” (p. 196)
- “For example, if you want to feel financially secure even if you lose your job, you can estimate how long it will take you to gain employment again, and then save enough to live off savings for double that amount of time.”
- That’s our baseline. But we need to adapt our margin of safety to the individual and situational circumstances. If the cost of failure is high, and outcomes are more consequential, you want a large margin of safety. For instance, if you’re worried about losing your job, and you’re in a sector or economy that’s volatile, you’ll want to increase the length of time you can take care of yourself while unemployed.
- If the cost of failure is low, and outcomes are less consequential, you can often reduce or skip the margin of safety. The longer something exists and performs well, the higher the probability that its pattern of success will continue. Coca-Cola isn’t going anywhere in the near future; neither is Johnson & Johnson.” (p. 198)
- “However, if you have a lot of expertise and data, you can reduce your margin of safety yet further. Here’s an example: Warren Buffett aims to buy stocks that are 30–50 percent less than their true value. So he has a 30–50 percent margin of safety on stocks. But he’ll pay close to a dollar on the dollar for stocks that he understands well. So there’s only maybe a 20 percent margin of safety on the stocks he’s the most confident in.”
- “One of Warren Buffett’s core tenets for buying a business is that if he doesn’t understand it, he doesn’t buy it. In other words, if he doesn’t have enough information to calculate a margin of safety, he doesn’t invest at all. He also knows that not all margins of safety will protect him—the goal isn’t to get it perfect for every stock he buys; it’s to use the best possible strategy for all his stocks in the big picture.”
- “Here’s the bottom line: Predicting the future is harder than it seems. Things are great until they’re not. If things are good, a margin of safety seems like a waste. When things go wrong, though, you can’t live without it. You need a margin of safety most at the very moment you start to think you don’t.” (p. 199)