The Margin of Safety in Value Investing

The central theme of what Warren Buffett and other successful investors all say is that one can never invest successfully by risking one's principal.

The Three Words

Benjamin Graham wrote in The Intelligent Investor:

"In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, "This too will pass." Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto - Margin of Safety."
Benjamin Graham, Chapter 20: “Margin of Safety” as the Central Concept of Investment, The Intelligent Investor.


Warren Buffett — Graham's most famous pupil — simply states the same rule as:

"Rule No.1: Never lose money. Rule No.2: Never forget rule No.1."
Warren Buffett, Adam Smith’s Money World: How to Pick Stocks & Get Rich, PBS (1985).


Billionaire investor and hedge fund manager, Seth Klarman, too says:

"Loss avoidance must be the cornerstone of your investment philosophy."
Seth Klarman, Margin of Safety: Risk-averse Value Investing Strategies for the Thoughtful Investor.


Peter Thiel, co-founder of PayPal and the first investor in Facebook. writes:

“First, only invest in companies that have the potential to return the value of the entire fund.”
Peter Thiel, Zero to One: Notes on Startups, or How to Build the Future.


When we study the methods of most successful investors, we see similar principles expressed and applied in different ways. But while almost everyone has heard of the Margin of Safety, in one form or another, only a select few such as those above understand it and apply it successfully.

Graham also gave the following definition in The Intelligent Investor:

"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
Benjamin Graham, Chapter 1: Investment versus Speculation, The Intelligent Investor.

The application of the Margin of Safety is actually best explained in Graham's definition of investment above, i.e., never risk the principal amount.

On Risk

Graham repeatedly emphasized this counterproductive nature of risk in investment.

Again, from the The Intelligent Investor:

"There has developed the general notion that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task."
Benjamin Graham, Chapter 4: General Portfolio Policy, The Intelligent Investor.

So Buffett was being quite literal when he said "Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.".

That's probably why he said it twice!

Graham Resources