In another era, Benjamin Graham, one of history’s greatest investors, opined in The Intelligent Investor about the importance of including a margin of safety in assessing the quality of any investment: “to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.” Graham’s many adherents, including the fabulously successful Warren Buffett, Bruce Berkowitz, and Seth Klarman (who even wrote a book entitled Margin of Safety), all also emphasize the importance of the concept of margin of safety.

Klarman says: “There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.”

Each of these supreme investors agree about the power of recognizing that the future rarely, if ever, unfolds how you modeled it to unfold.

So what is the lost art of the margin of safety? In short, the margin of safety is a “fudge factor,” a specific amount of extra conservatism built into your estimate of value for a security, because:

• The future is unknowable.
• Preservation of capital, not return on capital, is Job One of investors.
• Your model is inevitably wrong.

Margin of Safety for Equity

Qualitative definitions of the margin of safety are mostly in agreement with one another and adhere closely to the definition given above. Yet, interestingly, there is no agreed upon quantitative definition of the margin of safety. This is what makes this concept an art!

To inspire your imagination, here are some possible quantitative ways of calculating the margin of safety:

If (Fair Value ÷ Market Price) – 1 ≥ Margin of Safety → Buy

Here a research analyst estimates the fair value of the equity of a business and compares this estimate to the market price. In order to purchase shares, the fair value must exceed the market price by at least the analyst’s preferred margin of safety. Here the margin of safety is arbitrary.

In my career, I usually used a margin of safety of 15%. Why? Because I figured that my fair value estimate was likely off by ±15%, on average (i.e., a 30% range). For Google (GOOG), this means your fair value estimate must be $635.31 if its stock price is $552.44.

If (Fair Value ÷ Market Price) – 1 ≥ Coefficient of Variation → Buy

My use of 15% above is entirely arbitrary. Clearly for some businesses where it is difficult to estimate their fair value, a 15% level may not make much sense. Likewise, shares in a utility, where cash flows and costs of capital are easier to estimate, you might use a lower margin of safety. If you believe this is the case, then you will like this measure better.

Here you want your margin of safety to be at least the coefficient of variation. The coefficient of variation is calculated as: 1-year standard deviation ÷ 1-year average stock price. Take Apple (AAPL), for example, its standard deviation over the last year is 14.9, and its average stock price (split-adjusted) is $102.02, making for a coefficient of variation of 14.6%. An analyst using this method would want her estimate of fair value to be $116.91.

Margin of Safety for Fixed Income

Fixed-income securities are a contractual obligation between a borrower and a lender. This contractual nature tends to shift the analysis for fixed-income analysts away from the valuation of individual securities, and instead onto an evaluation of the credit worthiness of the issuer. Analysis at that level is definitely one version of a margin of safety. However, many analysts simply take the overall credit rating of the issuer, or its issue, from a credit ratings agency at face value to determine the appropriate credit spread to value a security.

Here are some possible alternative versions of a margin of safety:

Collateral

Proof that the margin of safety is a lost art, even in the realm of fixed income, is the overwhelming number of “unsecured” issues in comparison to “secured” issues. Secured means the fixed-income security is backed by collateral — alias, a margin of safety. Thus, if you want greater margin of safety, buy more issues backed by collateral. In a mortgage-backed security, you would want high levels of equity backing the mortgages.

Use the Credit Spread of One Credit Level Lower

Fixed-income investors could also use a more conservative credit spread in their calculation of fair value for an instrument than that implied by an issue’s credit rating. So if an issuer has an A- credit rating, then analysts could use the credit spread for BBB+ issuers for a similar maturity length security in assessing fair value.

Add a Premium to the Credit Spread

Another alternative is simply to add an arbitrary percentage amount to an issuer’s credit spread. If the spread is 150 basis points (bps), an analyst could add 15%, or about 173 bps, to use when assessing the fair value of the instrument.

As an example, the fair value price of a €1,000 par, 3.5%, 2-year note — with a comparable euronote bearing an interest rate of 2.5%, and a credit spread for this type of issuer being 1.5% — would be €990.48. But, what if instead, the analyst builds conservativism into the spread, and makes it 15% higher, or 2.5% + [1.5% x (1 + 15%)] = 4.225%? Here the fair value estimate falls to €986.23.

Margin of Safety for Derivatives

Derivatives are the modern superstars of finance with many risk factors and sensitivities to these risk factors an explicit part of the daily discussion of such securities. So you would think derivatives must have a built in margin of safety. But I would argue that nowhere is margin of safety more of a lost art than in derivatives pricing!

Most derivatives investors do not have an independent assessment of the valuation of the underlying security. Instead, they take the market price of the underlying at face value because they simply want to calculate the price of the derivative itself. Likewise, the value of the derivative comes from a modeled price; consequently, the price of the derivative is taken at face value, too.

Risk management is handled after the fact by hedging. As the market fluctuates, derivatives investors simply adjust their hedge. But this assumption relies upon a liquid and stable market for these assets. If the market suddenly moves — exactly the moment when you want a margin of safety — it can be very difficult to adjust the hedge. In other words, there is no margin of safety built in to the valuation of derivatives.

Here are some suggestions for margin of safety for derivatives:

Have a Fair Value Estimate of the Underlying Security

I am guessing that to most of those involved in options trading this seems like a ridiculous consideration. But is it? If you get the options price correct, but the underlying security is massively overvalued and you are long calls, then you have some trouble on your hands, right? If you do not create an estimate of fair value, is there a source that you trust for such things?

Use Lower Volatility Assumptions

Option prices are directly tied to the volatility assumptions embedded in them. As a bit of conservativism, why not use a lower volatility assumption? Discount it in a similar fashion to those methods suggested above for other instruments.

Use More Conservative Assumptions for “The Greeks”

Different Greeks have different effects on different options. But if you are interested in preserving more of your capital and accounting more for an uncertain future, why not use more conservative assumptions for your Greeks?

In conclusion, margin of safety lies at the heart of the success of many great investors. Yet, it is a lost art. And not just in equity investing, Across the financial landscape, margin of safety is ignored . . . at your peril!

Photo credit: ©iStockphoto.com/HerminUtomo

Originally published on CFA Institute’s  Enterprising Investor.