Prepare Yourself with a Margin of Safety

When trading in the stock market, using a margin of safety can be to your advantage. A margin of safety gives you some room to work with if you were not completely accurate with your stock projections. Here are the basics of a margin of safety and how you can use one.

Margin of Safety

A margin of safety is an extra margin that you allow yourself when you are purchasing a stock. This is used in order to give yourself some cushion if you did not accurately project what a stock was worth. With a margin of safety, you are only going to purchase stock if it is priced significantly below what you believe it is worth. By using a margin of safety, you will be able to successfully eliminate a large portion of risk. This creates less chance of a stock falling below the price at which you purchased it. By using a margin of safety, the investor is going to be able to eliminate the fear that comes with trying to properly evaluate the value of a company. If the trader was wrong, they will still have some margin for error built in to the purchase of the stock. 

Example

It is easier to understand what a margin of safety is when you see it in action. For example, let's say that you have done your homework and determine that a stock was valued at $20 per share. Presently, the stock is trading for $20 per share. At this time, you would not buy it. However, the stock price later drops to $15 per share. When this happens, you purchase the stock because it is priced significantly below what you believe it is worth. In this case, your margin of safety is $5 per share. If it turns out that the value of your stock was actually only $18 per share, you are still going to be doing well because you bought it at $15 per share. 

Choosing a Margin

There is not a specific formula that can be used in order to determine what a suitable margin of safety should be. This is an individual decision that is different for everyone. This is a matter of your risk tolerance. Only you can decide what is a proper margin to work with.

The basics of evaluating a stock involve trying to determine the intrinsic value of the company. Investors determine the intrinsic value of the company in many different ways, using many different valuation multiples. Because of this, determining a proper margin of safety is going to be different for everyone. Some people might want to have a very large margins of safety because they are unsure of particular companies. At other times, individuals might be very confident in the valuations that they have done on companies and require only small margins of safety.

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