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Margin of Safety

Definition

A contingency or buffer to keep one safe from a negative or unfortunate outcome.

In engineering, it’s a concept that describes a system’s capacity to bear greater loads than anticipated.

In finance, investors use the term to purchase securities when the market price is below their intrinsic value.

In accounting, it refers to the discrepancy between actual sales and break-even sales.

Why Use It

The margin of safety is a critical part of some decisions to absorb miscalculations, errors, or just plain bad luck.

  • It’s a built-in cushion that allows for financial losses without incurring significant adverse outcomes.
  • It’s an added layer of safety for engineering projects where unforeseen circumstances might test a project’s infrastructure.

Its applications are myriad.

When to Use It

​​When unexpected problems emerge, establish a buffer between what you expect to occur and what could happen.

When you’re generating a maximum capacity for a load, the question is how much more durable the system will need to be to sustain an average load. Considering that testing bridges, buildings, and the like is impractical, analysis and modeling are required to deliver a level of confidence and accuracy in one’s assumptions.

In software, running a server near capacity might save money, but it leaves the site vulnerable to spikes in traffic. Load balancing servers and setting up auto-scaling mitigates that risk and lessens the likelihood of a catastrophic failure.

It is used in accounting to buffer break-even forecast estimates.

Keeping a margin of safety is vital in numerous fields because it deals with the consequences when things go wrong.

How to Use It

Suppose you are constructing a bridge with a maximum weight of 50 tons; you wouldn’t want a 50-ton truck to cross that bridge in case it’s a few pounds over the limit. So, if the expectation is for 50-ton trucks to cross that bridge, then an engineer would ensure the maximum weight is up to five times that.

A more common example is changing the oil in your car every five to ten thousand miles. Carmakers have tested oil changes that occur thousands of miles past the prescribed amount but know that real-world wear and tear varies. Running out of oil could damage or ruin the engine altogether, so it’s in the carmakers’ best interest to replace the oil sooner because there are too many unknowns. A failure of this nature is both dangerous and expensive.

The same is true about monthly expenses and budgeting. Saving money adds a buffer for unexpected costs if you lose your job or cannot work for other reasons. Moreover, reducing expenses enough to where you’re saving more than 50% of your income compounds and allows you to guard against acute financial stress, like a large medical bill.

And it also works for managing complex projects where multiple people are working on discrete tasks that need to be completed in sequence. If ten people each require two days to complete their task, it would take ten days to finish. When estimating, give each more time and plan for the worst-case scenario; it’s the best way to mitigate risk.

    How to Misuse It

    All information has some degree of error, and using it as the basis of your research comes with some level of uncertainty. When analyzing data to create a margin of safety, take into account its age and biases. Without prudence, a calculation can easily be exaggerated.

    Next Step

    Using a margin of safety is beneficial for time management, budgeting, or a project. Find ways to build this valuable tool into different aspects of your life.

    Where it Came From

    Benjamin Graham and David Dodd coined the term margin of safety in their 1934 book, Security Analysis.

    What Are Mental Models?

    Mental models are thinking tools that help guide and shape our perceptions of the world. They simplify complexity so we can understand life better, make decisions confidently, and solve problems.

    Deep Dive Into Mental Models

    Deep Dive Into Mental Models

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