Margin of safety: folk wisdom meets the low volatility anomaly

A common theme among value or fundamental investors is that stocks should have a “margin of safety”, so as not to lose all their value, go bankrupt or be restructured, when they encounter difficulties. This is solid common sense, yet has no obvious rational reason to be true.

Like any quality, or defect, an investment might have, it’s possible to discount that advantage or defect, and market forces should tend to. In a perfectly efficient market every investment returns the same in risk adjusted terms.

Photo of dice

Expected value? (credit: Toshiyuki IMAI)

In a simple example, which portfolio would one choose between a basket of stocks who have a binary outcome of their value tripling or going to zero, with balanced odds (half fail and half succeed) and a portfolio of stocks where half stay flat, and half grow by 20%; or equivalently are distributed within that range. For a portfolio large enough we get returns (expected value):

  • risky portfolio: 50% (1.5 = 3 * 0.5 + 0 * 0.5)
  • sedate portfolio: 10% (1.1 = 1.2 * 0.5 + 1.0 * 0.5)

Anyone should pick the risky portfolio. Through diversification, we can re-introduce the “margin of safety” to the portfolio as a whole, however risky the individual items. All that matters is the pricing relative to expected value of each investment, as long as the risk is individual (idiosyncratic and not correlated).

Of course in practice it seems to turn out — this is an expression of the low volatility anomaly — that the price of risky investment seems to be higher than the rational expected value. Hence the “margin of safety” rule of thumb being usually a good one to follow.

Good rule, wrong story, I would say. It is very much like folk wisdom often is.

It just captures the low volatility anomaly with an inaccurately simplistic story, which could be detrimental if low volatility became expensive, or when risky investments with little margin of safety are genuinely, if unusually, good value in probabilistic terms.

  1. I once heard a commentator say, we need to stop bankers taking these high risk high reward bets.

    Unfortunately, the problem seems to be we, and I mean all savers, instead we want low risk, high reward bets which of course don’t exist.

    The focus on optimising risk reward at a local level is leading to retry low global equilibrium because not enough risk is taken to grow the economy.

    I might write about this!

  2. cig said:

    I think we might be close/past peak low risk really. The system is dynamic and the supply side responsive, after a while. For instance people identify steady dividends with low risk, and it may have been a fair proxy in the recent past, but anyone with any kind of risk can do that with a bit of financial engineering, and because it’s where the money currently is, they (will) do. And it’s just one example of a broader pattern.

  3. I’d hope so. I’d be interested in any examples you have that it’s passing because I suspect it will be a crucial point for the global cycle.

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