Complex systems are unpredictable and don’t always work as anticipated. There are too many variables and interdependencies to fully understand them. Any input might change the system and some might lead to large unintended consequences. In some cases, the rules of the system might even change completely.
A margin of safety acts like insurance against this unpredictability. There is an expected outcome to every action. A margin of safety is the buffer you add on top of the expected outcome in case you are wrong. Factoring in a margin of safety makes systems able to withstand extremes instead of just average cases and adds an additional layer of security to every action.
The concept is used extensively in various fields such as finance, engineering, medicine, systems theory, and accounting. This is reflected in the variety of different forms a margin of safety can take. Examples include financial buffers, data backups, plan Bs, etc.
The size of your margin of safety should depend on the cost of failure and the level of unpredictability. The higher the cost or unpredictability, the larger your margin should be.
“The three most important words in investing…Margin of Safety.” – Warren Buffett
Warren Buffett is one of the greatest investors of all time. His investment style is based on a few fundamental principles, one of which is margin of safety.
In investing, a margin of safety is the difference between the market evaluation of a stock and its intrinsic value. If the intrinsic value is higher than the market price, the stock is cheap and considered a good investment.
Buffett is under no illusions that he understands the market and the business he’s investing in perfectly. There is always imperfect knowledge. Hence, he makes sure that the margin of safety of every stock he’s investing in corresponds to his level of uncertainty.
“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.” – Warren Buffett
Runway is another form of margin of safety. When a plane has no more runway it crashes. For a startup, runway is the time it has with its current burn rate until the money runs out. The same applies to personal finance.
I personally make sure that at any given time I have at least six months of runway. This means that in case I don’t get any more income (business defaults or lost a job) I can sustain myself with the current burn rate for at least six months.
This timeframe is based on my estimation of the current situation and my personal risk profile. If the economy and the job market get worse, I’d adjust the margin up. If I have diversified my income to different sources, I can reduce it.
In medicine, the therapeutic index describes how safe a drug is by comparing the amount of a drug needed for an effective therapeutic impact with the dose that is toxic. This window is the margin of safety. If that margin is too small, a drug won’t be approved since the danger of accidentally poisoning someone is too high.
“In the early days of pharmaceutical toxicology, TI was frequently determined in animals as lethal dose of a drug for 50% of the population divided by the minimum effective dose for 50% of the population. Today, more sophisticated toxicity endpoints are used.” – Wikipedia
Prepare for the worst when it counts
Whenever there is a decision to be made, think about what could go wrong. What is the worst that can happen? This is not the time for optimistic thinking. What if everything goes wrong? Can you survive the fallout? Think about all possible scenarios and preparations you could make.
Your margin of safety should be based on
- the consequentiality of the worst outcome, and
- the amount of unpredictability or uncertainty inherent around your confidence that the worst outcome is truly the worst possible.
Practical exercises that help with this:
- Fear setting exercise by Tim Ferriss.
- Red teaming: A practice where a friendly team simulates the enemy and tries to actively surpass or sabotage defenses and security measures. It’s used in the military, cybersecurity and other security related fields.
Learn more than what is required
“We learn enough to solve today’s problems but not enough to solve tomorrow’s.”
- The Great Mental Models Vol. 03, Farnam Street
Often, when we learn things for a specific use case we do so superficially. Maybe you need to learn how to create an email campaign for work. You learn the mechanics of how to set it up and maybe some basics to create one. This might help you with the task at hand, but as soon as the used tool changes or the rules around how the campaign is done at your company you’re lost. Instead, you should aim to learn the fundamental principles of email campaigns and email marketing to understand them deeply. This knowledge doesn’t expire so easily and is more adaptable to different challenges.
The concept has several limitations.
First, a margin of safety can make us overconfident. We might fool ourselves into believing that we know the risks and have eliminated uncertainty. But the margin just insured us to the cost of being wrong. We might still have missed something or underestimated the worst-case scenario.
On the flip side, it can make us too cautious. We might waste precious time and resources building a buffer that isn’t needed for risks that aren’t there. We might use the margin as an excuse to not take action and buy time. This can be dangerous.
Lastly, we might adapt our behavior to account for the margin of safety. Knowing that we have a buffer we might take larger risks than without it. This way the margin doesn’t provide any additional security.
The armor. Even a skilled swordsman goes into battle with protection. The armor might inhibit his movement and slow him down, but he knows that he can’t control everything about the battle. The armor protects him from an unseen arrow or a blade from behind. It’s his margin of safety.
“The professionals plan for ‘mild randomness’. They learn from averages and overlook the outliers. Thus they constantly, predictably, underestimate catastrophic risk.” – Benoit Mandelbrot