Warren Buffett and Charlie Munger were once asked about the concept of Margin of Safety. The question was as follows:

"How do you judge the right margin of safety to use when investing in various common stocks? For example, in a dominant long-standing, stable business, would you demand a 10% margin of safety? And if so, how would you increase this in a weaker business?"

Warren quickly answered:

"We favor the businesses where we really think we know the anwer. And therefore if a business gets to a point where we think the industry in which it operates, the competitive position, or anything is so chancy that we really can't come up with a figure, we don't really try to compensate for that sort of thing by having an extra large margin of safety. We really try to go on to something we really understand better."

So the first point is that you need to understand the business, and that you shouldn't think that you can compensate with a high margin of safety if you have no idea of in what range the future earnings will look like.

He continued:

"So we buy something like a business like See's candy, or The Coca-Cola Company as a stock. We don't really think we need a huge margin of safety, because we don't think we're going to be wrong about our assumptions in any material way.

But what we really want to do is to buy a business which is a great business, which is a business that earns a high return on capital employed, for a very long period of time, where we think the management will treat us right.

We don't have to mark those down a lot once we find those factors. We'd love to find them when they're selling for 40 cents on the dollar, but we will buy those at much closer to a dollar on the dollar. We'll pay something close. And if we really get to something, you know, when we see a great business, it's like: When you see someone walking in the door, you don't know if they weigh 300 pounds or 325 pounds, you still know they're fat! So, if we see something where we know it's fat financially, we don't worry about being precise. And if we can come in at that particular example of the equivalent of 270 pounds we'll feeel good."

Once you find great businesses to invest in, you don't need much of a margin of safety, because the returns of the business will be good. The great businesses deliver high returns on capital, and if you can hold such a business for a very long time, it's alright as long as you don't overpay for the stock.

"But if we find something where the competitive aspects are so that you can't see out five or ten or twenty years, we might be speculating. Because that's what investing is, it's seeing out! You don't get paid for what's already happened. You only get paid for what's going to happen in the future. The past is only useful to you in extent of which it gives you insights into the future. And sometimes the past doesn't give you any insights into the future. And in other cases like in the stable business that you postulated, it probably does give you a pretty good guideline as to what's going to happen in the future, and you don't need a huge margin of safety.

You should always feel that you're getting a little more than it's worth. And there are times when we've gotten to buy businesses at a quarter of what they're worth. We saw it in Korea recently, but you don't see those sorts of things very often. And does that mean you should sit around and wait 10-15 years? That's not the way we do it. If we can buy good businesses that are of reasonable valuation, we're going to keep doing it."

Charlie Munger added:

"The margin of safety concept boils down to getting more value than you are paying. And that value can exist in a lot of different forms. If you are paid 4 to 1 on something that's an even money proposition, well that's a value proposition too! It's high school algebra. And people who don't know how to do high school algebra should take up some other activity (than investing)!"

Want to pick up the book that tought Warren about the margin of safety idea?

If you want to read more about the margin of safety concept, feel free to buy a copy of The Intelligent Investor. Warren Buffett claims chapter 8 and 20, one of them being a chapter about Margin of Safety, are the two most important chapters in the book.

Buy a copy of The Intelligent Investor here! (affiliate)

Interested in other books? Go to our recommended books page here.