subscribe to the RSS Feed

Sunday, April 23, 2017

Margin of Safety

Posted by Tim Stobbs on April 8, 2009

I have a theory I wanted to share with you all.  When doing retirement calculations people pick all sorts of margins of safety.  They add an extra 10% to their spending, or reduce their investment return by 1% , or choose a higher inflation number, or in some cases they do all of the above.  I’ve always wondered why people pick different margins of safety.  Some pick very lean margins and others very fat margins.  I think I know why.

I theorize that people pick margins of safety that are directly proportional to how willing they are to accept their back up plans or the concept of failure.  So those without any back up plans and who have not even thought about ‘what’s the worst that could happen’ end up picking higher margins of safety than those who have back up plans and accept them as valid options.

Now obviously there are other issues around choosing the margins.  If you are more conservative investor you will obviously choose a lower rate of return to do your calculations or if you have previously been through a period of higher inflation you are likely to pick a higher number.  Your previously experience in life will also influence your choices.

Yet in the end, I believe the margin of safety is really a measure of your fear of the situation.  So by planning out some back up plans and asking your can you live with them you remove that fear and hence chose a smaller margin of safety.

Well that’s my theory.  What do you think?  Is it crap, am I on to something, did I miss something?  Please share your thoughts with a comment.

Comments

6 Responses to “Margin of Safety”
  1. Adam says:

    It’s all about how big a bullseye you want. It’s always easier to hit a larger bullseye.

  2. Part of reality is the surprises we were not even thinking about. Taleb calls them Black Swan events.

    For example, when I safety margined my income for retirement I did not know that 5 years into retirement the market would crash as much as it has. As a result, I have a dependent that may remain a dependent longer. In addition, my pension fund recently sent out a letter warning that pensions have the potential to be reduced if the fund loses a larger amount than ‘their safety margin’ allowed for (my words not theirs).

    I think it is always good to have a healthy safety margin in all things. I always look twice when crossing the road and when changing lanes. Every decade or so that habit has kept me from having an accident. So safety margins are applicable with non-dollar issues as well.

    In one instance, I would have been killed crossing the street by a speeding car going through a stop. It was intially hidden from my view by a bus at the stop sign who allowed me to cross in front of it. I came close to dying about 2 years before retirement…that would have been a bummer!

  3. Hazy says:

    Isn’t having a backup plan and having extra cash basically the same thing?
    Both could reduce the fear of failure and provide a margin of safety.
    Sounds like risk management to me…a good good thing to do.

  4. chad says:

    with gic rates so low does that mean the margin of safety is riskier being in the market?

  5. mfd says:

    I am definitely one of those with a conservative margin of safety. I calculate my returns at 5% and inflation at 3%. I don’t think its fear that causes me to do it. I figure if I can over come the challenge of achieving my goals in a worst case scenario (high inflation, low returns) then if things turn out better I may be able to retire sooner or be able to start spending a bit more money.

  6. Canadian Dream says:

    Adam,

    Good point. That is part of it.

    Hazy,

    I actually usually treat backup plans separate from the margin of safety. I consider back up plans like down sizing your home, or working part time. They are typically things you don’t want to do, but can if you need to. Margin of safety is mostly about extra cash.

    Chad,

    I don’t understand your question.

    MFD,

    Good point. Being conservative does have the advantage of you typically won’t be disappointed by working longer than you thought.

    Tim

home | top