Having a built-in cushion when you go on a risky investment venture is a great idea. Indeed, in its absence, the failure of an investment project can have a very painful effect on your finances. In economic analysis, such a cushion is called the margin of safety, and the higher this indicator, the more reliable it is considered.
What Does a Margin of Safety Mean When Buying Assets
The idea to invest your free money in any asset can come to your mind at any moment. For example, you received an inheritance or premium, won money in the lottery, etc. However, do not rush to fulfill your plans, as this may be exactly the moment when the prices of your chosen asset in the market exceed its intrinsic value. And when they collapse, which they will certainly do it sooner or later in such a situation, you will realize that you have invested much more money in this asset than it is worth in reality.
Therefore, professional investors advise to buy assets when their market price is significantly lower than their intrinsic value. This difference between their intrinsic value and the price you paid for them is a margin of safety. The higher this margin, the less painful further price fluctuations will be for your finances, and possible losses will not become critical.
How Big Should the Value of the Margin of Safety Be
There is no single correct answer to the question of what should be the margin of safety to purchase an asset. Your decision depends on personal risk preferences:
- If you are a conservative investor, it should be large enough to give maximum room for value growth.
- If you are ready to accept risks and challenges and believe in your luck, you can decide to buy an asset even with a slight cushion.
Therefore, to determine this indicator, you must answer two questions:
- What type of investor do you belong to?
- What returns do you expect for this asset?
And depending on the answers, set your own personal threshold values for the margin of safety. However, remember that most professional investors prefer this value to be at least 20-30% of the value of the asset.
What Is the Margin of Safety in Lending?
When you apply for a loan, lenders also take the margin of safety into account. For them, it means the difference between the price of collateral and the loan that it issues. Since lenders want to be sure that their money will be returned to them even if the borrower defaults, they prefer the margin of safety to be high enough.
However, if you do not want to pledge collateral, choose payday loans since, in most cases, this is “unsecured” debt. On the Payday Depot platform, you can compare the conditions of different lenders and financial institutions and choose the one that does not ask for collateral.
Whatever financial action you take, such as investing, borrowing, or lending money, starting your own business, etc., always keep the margin of safety in mind. This is a very important part of risk management that will save you in highly volatile markets.