Margin Of Safety

If it can go wrong, assume that it will

Dreamstime

Margin Of Safety - Overview

Margin of safety is an  engineering concept and is a measure of how much extra load will a structure actually take beyond what is intended.

It is also commonly applied in finance as where it is a measure of the difference between the intrinsic value of a stock and its market price. It is also applied in accounting in break-even analysis, and is a measure of how much output or sales level can fall before a business reaches its break-even point.

Margin of safety has wider applications in everyday life and can also be referred to as slack.

The basic colloquial meaning is:

Example 1. Air travel

Before the coronavirus pandemic I flew extensively around South East Asia and at least 4 times a year, return flights to the UK.

Having had one or two nasty incidents of nearly missing a flight I developed a routine of always getting to the airport at least an hour before the required time. I would have coffee and do some work in the lounge and use the waiting time productively. This was my margin of safety and it enabled to feel very relaxed and stress free.

One day, when I was in Singapore, I took a taxi to Changi Airport and upon arrival the taxi boot jammed and the driver could not remove my case and my laptop.

It took the driver and airport maintenance staff about one and a half hours to retrieve my baggage.

The taxi driver commented on how relaxed I was and ask me why I was getting stressed and angry, and I explained about my margin of safety.

I made the flight!

Example 2. Sales and Business Forecasting

For the first of my career I was a professional salesman and was required to produce monthly sales forecasts.

I very quickly realised that my forecasts were over optimistic and reflected my enthusiasm and positive expectation.

To counter this tendency I developed a heuristic what I called the rule of two.

Example 3. Renovating Old Houses

In the UK there are a lot of older properties. I have lived in several and have undertaken projects to renovate and improve these houses.

Each time I have applied "The Rule Of Two" and is has proved very helpful.

Not only does it ensure that I budget double what the builders and craftmen quote me for the work [obviously I don't tell them I have done this!]  but I always assume there will be unforeseen issues and problems and also that it will take twice as long as the builder has indicated.

What actually has happened each time is that the final cost has been somewhere between the original quote and my increase budget, and the same on the completion date.

Applying The Margin Of Safety

Outside of the worlds of engineering, business and investment how can we usefully apply the mental model of margin of safety?

The first and most obvious application is to keep us safe.

"Safe" may not in the everyday sense be about saving life but it is everything to do with reducing stress, peace of mind and the management of our own and other's expectations.

So in this instance we are thinking about "safe" in terms of quality of life.

Here are 3 pointers:

[1] Be Careful In Your Assumptions And DON'T Exclude The Fat Tail

In the Pareto Principle we considered The Bell Curve and what is referred to as standard distribution and the 80/20 Curve referred to as a power law distribution.

You don't have to be a statistician to understand and benefit from understanding that there are many situations where the Bell Curve does not apply and the 80/20 curve does - and this is because there is a relatively high probability of extreme outcomes.

Extreme outcomes - such as at time of writing the corona-virus pandemic - can and do occur.

Clearly there are limits as to how far it is reasonable and, more to the point, affordable to put in place contingencies, but you should at least make a conscious choice to do nothing.

[2] Ask: "...and then what?"

Second Order Thinking goes beyond the obvious and seeks to avoid unintended consequences by asking: "...and then what?"

This is more deliberate thinking and is about seeing things that other people don't or can't see.

It is about thinking in terms of interactions and time, and considering the consequences of a potential decision or action. It is only by thinking like this that you can build in your margin of safety.

[3] Think About Your Objective In Reverse

Apply Inversion. Instead of thinking forward about what you need to do to get what you want, you spin it round and in reverse, away from your objective, about what you don’t want to happen.

By simply thinking about what you want to avoid or the opposite of what you want to achieve, you can plan effectively to prevent failure and ensure that you have included a margin of safety.

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