In this video we're going to talk about the margin of safety and how you can use it effectively to reduce
risks on your investment and make a wiser investment decision.
So what exactly is margin of safety margin of safety is simply the difference between the intrinsic
value of a stock and its market price.
For example the market price of a stock is six dollars a share.
You find that its intrinsic value is about $10 a share.
So in this case we have a margin of safety of $4 or 40 percent.
In fact the higher the margin of safety the lower the risk on your investments the margin of safety
is achieved when a stock is bought at a price which is sufficiently below underlying value to allow
for human error bad luck or extreme volatility in a complex unpredictable and rapidly changing world.
In other words using a margin of safety will allow you to correct your mistakes in your investment analysis
and valuation Well when it comes to stock valuation.
We make mistakes all the time.
You know every valuation method is implemented based on assumptions.
For example when using the discounted cash flow model you'll have to assume that a company's cash flow
will grow at a consistent rate over the next five to 10 years.
What will happen if its cash flow grows by 10 percent this year 5 percent next year and negative 8 percent
in another year.
You see our valuation method is somewhat biased and that's why the margin of safety concept is applied
to value investing.
So how much margin is acceptable.
Well it depends on how much bad luck you're willing to face.
Your risk tolerance and how much money you can afford to lose.
Losing some money is an inevitable part of investing.
In fact there's nothing you can do to prevent it but to be as sensible an intelligent investor you must
take responsibility for ensuring that you never lose most or all of your money.
If you think you can't afford to lose much from your stocks it always pays to have a good margin of
safety say around 30 to 40 percent.
This means that you must buy a $10 stock for not more than six or seven dollars.
Remember the higher the margin of safety the better.
And also make sure that you will always use a margin of safety about least 25 percent for the sake of
your money safety.
In the next module.
We'll dive into some investing principles that you should always keep in mind when investing in the
stock market.
OK.
See you in the next video.