Margin Of Safety
The margin of safety. Sometimes called room for error or safety buffer. We know it’s important, but how many of us intentionally plan these into our lives?
According to google maps, it takes exactly 22 minutes to drive from our home to the closest trader joe’s. But if you’ve driven a car for any period of time you know we shouldn’t allow ourselves exactly 22 minutes right? We should leave some buffer room. There could be traffic, an accident, or some random hailstorm.
So in this post, I want to share with you 8 ways to create a margin of safety when it comes to our finances and life in general.
01 - Assume All Forecasts Are Wrong
In my previous life, a good chunk of my work was making forecasts of the future.
How much revenue are we projecting by the end of next quarter?
Where do we think our final insurance premiums will land?
Do we think this department will overspend in its operations budget?
We used a lot of pretty complex tools to make these forecasts as accurate as possible. But the truth was at the end of the day, we never really knew. I thought the insurance premium would end at a certain number based on historical trends. But because of an unexpected medical procedure, the numbers came in much higher than anticipated.
I was sure our revenue projection was right because I was incorporating the most up-to-date and sophisticated assumptions in my model. Yet come to the end of the quarter and we would be off by quite a bit. It’s not to say that all forecasts are useless because they do play a role in helping us plan for the future. The issue is when we overly rely on them as the truth rather than forecasts that they are. Which leads to the next way to create additional margin.
02 - Beware Precise Numbers
In the line of all forecasts being wrong, the more precise the prediction, the warier we should be of them. We see this in the financial media all the time. Market forecasters don’t say market returns will be somewhere between 3 to 6% next year, they say based on the current trend it will increase by 3.4% next year. Stock analysts don’t say the stock will likely be somewhere between $80 and $100 dollars next quarter. They say the stock will hit $92.50 in March.
We had a term for this in finance. Called “False Precision.” Finance people love precise numbers because when numerical data are presented with specific numbers, it conveys a more precise picture than reality. And to add to that, when we speak with unshakable certainties people trust us more. No one wants to listen to us when we talk about probabilities and possibilities. But know that all forecasts are wrong because no one knows what the future holds. And the more precise their forecast, the more wrong they likely will be.
03 - Expect The Unexpected
One of my favorite movies is an old military classic called The Bridge Too Far. A 1977 epic war film depicting Operation Market Garden, a failed Allied operation in Nazi-occupied Netherlands during World War II. It’s got your full ensemble cast. Sean Connery, Gene Hackman, Anthony Hopkins.
A Bridge Too Far (1977)
The main essence of the movie was this. The Allied forces make the bold decision to take over a series of bridges, seven to be exact, deep in enemy territory in order to launch their offensive against Germany and win the war quickly. In their planning, they made a lot of assumptions to guide their overall strategy.
Based on known intelligence reports, they thought they knew exactly how many German soldiers were in the area of operations. They assumed their convoy could move at a certain speed each day. They assumed they could land a certain number of paratroopers near each bridge by a specific timetable. However, all their assumptions were quickly thrown out the window as soon as the planes took off and bullets started flying.
There were way more German troops than expected. Highly trained ones at that. The convoy couldn’t move fast enough because there was resistance at every bridge. And due to bad weather, crucial paratroopers could not land where and when they were needed. In the end, not only did the allied troops fail to take over all of the bridges in time, they lost thousands of soldiers in the process.
The main lesson was this. Expect that we will never know everything. Expect that the unexpected will always arise. No one could have guessed that COVID-19 would take center stage in the past couple of years. No one could have guessed that home prices would have risen as quickly as they did. And no one could have guessed the war in Ukraine would last this long.
The reality is that we can never know what life holds for us next year or the year after. Let’s incorporate a margin of safety in everything we do. Especially in our finances.
04 - Conservative Return Assumption
Segwaying from our earlier points, forecasts are never accurate. And there will always be surprises around the corner. So when it comes to our portfolios it is crucial that we don’t assume what happened in the past will play out exactly in the future. Use a margin of safety when estimating your future returns. And because we don’t know what the future holds, to be honest, this is more art than science.
The S&P 500 had a return of approximately 10% annually over the past 100 years. If we assume that what happened in the past will project out to the future, we could use 10% for our portfolio. But given we are talking about a margin of safety, we wouldn’t want to use this as an expected return going forward. I personally like to dial this back. Maybe 8% or even 6%. Whatever makes you more comfortable.
And when we do this, it means we will have less money in the future. So in turn we will need to make adjustments today. Either by saving more. Or earning more. Or ideally both. Of course no margin of safety offers a 100% guarantee, but it is nonetheless important to think about. And the nice aspect of incorporating a more conservative return assumption is that if the future does resemble the past, it will be a nice pleasant surprise for all of us.
05 - Worst Case Scenario
Constantly ask this question whenever we are about to make a big decision. What is the worst-case scenario? What is the worst that can happen if this plan doesn’t work out the way we planned? You decide to buy a nice home. But it requires all the money you have to put as a downpayment. And let's say the worst case scenario happens and you lose your job. Would you lose your house as well? How financially devastated would you be?
If you are in a position where losing your job can wipe you out, maybe you might be taking too big of a risk with that house purchase. You probably want to create some additional margin of safety before purchasing that dream home of yours. And this worst-case scenario question can work the other way as well. Enable you to take risks that you thought were too risky before.
Let’s say you always wanted to go back to grad school to pursue a new career. But you’ve been too scared to make the move. Think through the worst-case scenario. If you have saved up enough money to last you for a few years. And you also have a great career capital that you can fall back on, maybe going back to school isn’t so risky. If it doesn’t work out after a year or two the worst-case scenario is you go back to your old job. Or because you have enough financial reserve, you can take some time off to pontificate about life. This leads us to the next way to create more margin of safety.
06 - Hold Cash
Cash in my books is the strongest weapon against the uncertainties of life. In order to succeed in anything, we need to first survive. Survive the uncertainties of the future. The unpredictable risks of the market. And our worst-case scenarios. Cash smoothes out all those factors so they feel like more of a speed bump than a full-out roadblock.
And this is sometimes hard to do for many of us who want to make sure our money is always working for us. We are always tempted to invest as much money as possible into the market. We want compounding to work its magic and grow our net worth. But make sure to hold some in reserve to create that margin of safety.
07 - Never Over Leverage
Leverage is simply taking on debt to make our money go further. It gives us the ability to buy a home or fund an education even though we don’t have the cash now. A moderate level is acceptable, however, the issue is that many of us push this tool to its extremes. Taking on unnecessary risks and eventually into something capable of destroying our lives. And we don’t have to look too far in history to see this.
During the 2008 housing crisis, many people overleveraged themselves and ended up owing more than their homes were worth. Some even had multiple homes. Using the leverage from one home to buy their next one in hopes that the real estate market would continue to go up.
What was worse was that homeowners wiped out during this crisis had no chance of taking advantage of low mortgage rates and cheap distressed homes in the following years. Lack of margin of safety not only led them to ruins but kept them from taking advantage of ripe opportunities when they presented themselves.
08 - Minimal Overhead
When I’m talking about overhead, I’m referring to how much your family needs to survive on a monthly basis. Food, transportation, housing, and clothing. For some families, this could be $200,000. For others, it could be $50,000. A lot goes into where one lives. But the major factor in this number is the lifestyle we have chosen for ourselves.
If you live in a multi-millionaire home and have 3 leased cars, your overhead will be expensive just by the nature of your lifestyle design. However, if you can dial in your home to what is minimally necessary for you and your family, and you don’t mind driving paid-for used cars, your overhead will be significantly lower. And when you have lower overhead, you naturally have created a margin of safety.
If your income drops, you are at a much-reduced risk than someone who needs much more money to live. And if you’ve watched or read any of my other content, you know I’m a firm believer in frugal living and this mantra of minimal overhead. I used to think wealthy people spent their money on nice homes, expensive cars, and fancy clothes. But I realize now that true wealth isn’t about how much money you make and show. Rather it's about what happens when your income drops to zero. How long can you survive?
