In daily parlance of investing in the stock markets, one generally comes around the two most used (and often misinterpreted) terms related to the subject - risk and return. While most of the stockbuyers are pretty much concerned and have (un)clear definitions about the latter, i.e., return, they generally fail to define 'risk'.
The definition of risk is very situational. For instance, in the 1999-2000 dotcom mania, risk meant not in losing money but making less of the same than anyone else. People, at that time, dreaded meeting others who were making more money through day trading. Then in early 2003, the definition of risk was changed to mean that the stock market would keep dropping until it wiped out whatever traces of wealth one had still left with.
In contemporary times, risk can be associated with paying a higher price for a stock that does not justify value of the holding or that already factors in the growth for the next few years. And in these times, it is an imperative for stockbuyers to give heed to one of the breakthrough concepts of investing given by the 'father of intelligent investing,' Benjamin Graham.
Known as the 'Margin of Safety,' this concept has been (and is) very essential while investing in stock markets. This concept, generally, applies for other investment avenues like bonds. For instance, a company must earn a pre-tax profit of more than five times the total interest cost for its bonds to qualify as investment-grade issues. In simpler words, if a company 'X' has interest charges of Rs 10 per annum, it should make Rs 50 as profit before tax for its bonds to qualify as investment grade instruments. The excess of profit after paying interest provides a sense of comfort for investors. And this is called the 'margin of safety.' This acts as a protection to investors against any loss in the event of some future decline in net profits.
Margin of safety means 'always building a 15,000 pound bridge if you are going to be driving 10,000 pound trucks across it'. - Benjamin Graham.
Now, can this concept of 'margin of safety' be applied to common stocks (or stocks)? Graham says yes, but with some modifications. For ordinary stocks, the margin of safety lies in an expected 'earning power' considerably above the interest rates on debt instruments. Simply calculated, earning power is equal to the reciprocal of P/E ratio, i.e., E/P. For example, a stock with a P/E ratio of 8 has an earning power of 1/8, or around 12%. In common parlance, this is often known as the 'earnings yield.'
Considering the above example, assuming that the stock has an earning power of 12% and that interest rates on a 10-year bond is 5%, then the stockbuyer earns an excess of 7% over bond, which is a margin in his favour. This excess of 7% when extrapolated to an investment horizon of 10 years aggregates to 70% of the initial price paid. While such bargains are hard to find in these times, the level of margin a stockbuyer considers safe is dependent on his ability to take risks.
However, having a stock with a high margin of safety is no guarantee that the stockbuyer would not face losses in the future. Businesses are subject to various internal and external risks, which may affect the earnings growth prospects of a company over the long-term. But if you have a portfolio of stocks selected with adequate margins of safety, you minimise your chances of losses over the long term. In this context, stock selection is of great importance. Now, while losing some money is an inevitable part of investing, to be an 'intelligent investor,' you must take responsibility for ensuring that you never lose most of all of your money.
To quote Graham, 'Margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, non-existent at some still higher price.' So, have you decided on your margin of safety? If not, do it now!
Note: Characters in italics are quotes from Benjamin Graham.