Investing with the Margin of Safety Principle

Risk taking is a necessary part of investing. However, it’s advisable to find a balance between the risk-taking extremes of all or nothing. We can define this as a margin of safety. Chris Farrell, Economics Editor of Marketplace Money and author of The New Frugality says in his book that a margin of safety is “the bedrock idea of personal finance for all seasons and at all ages, from a high school graduate trying to decide between public university and a private college, to an aging worker wrestling with how much money to put into fixed-income securities and how much into equities.”

Seeking a margin of safety regardless of age or financial position will help you avoid getting rich quick schemes on one end and operating out of the fearing of a financial crisis on the other. One classic example of putting the margin of safety principle into practice is establishing an emergency savings fund that would pay for household expenses for up to a year. This creates a margin of safety against layoff and would give the financial freedom to change jobs. Another example of the margin of safety principle is purchasing life insurance to protect family members from the provider’s unexpected death.

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Chris Farrell recommends what he calls the “almost perfect margin-of-safety product:” investing in a Roth IRA. The reasons he states to back up his recommendation is that “it’s both a long-term retirement savings plan and a parking place for emergency money.” He advises steering clear of high risk investments like options, futures and collectibles because they don’t provide much of a margin of safety. Make wise investment selections by avoiding risk-taking extremes and by seeking investments that offer a margin of safety.