Building in a Margin of Safety
In 2005 Hurricane Katrina hit New Orleans killing over 1,800 people. Most of the deaths were due to the failure of the flood protection system around the city known as levees. A 2007 study by the American Society of Civil Engineers called the flooding of New Orleans “the worst engineering catastrophe in US History”.
What went so wrong? In the investigations and reports that followed, it was concluded that the engineers responsible for the levees made several mistakes. They overestimated the soil strength and applied just a 30% margin over the maximum design load. They also failed to take into account the possibility of a water-filled gap which turned out to be very important. The error due to the water-filled gap was about 30% which immediately used up the entire safety margin and left no leeway in the design.
Normally when building public structures such as bridges, engineers use a doubling of strength as a typical safety margin. A heavy truck in the US can weigh around 80,000 pounds. An engineer would not build a bridge to support 80,000 pounds. She would build a bridge to support perhaps two fully loaded trucks, and however many cars that could fit in heavy traffic, and some parked on the hard shoulder. And then she would double that load.
When you drive over that bridge, you want to know that such a margin of safety exists. You assume it is there.
We build margins of safety into our lives all the time. Think about the last time you had to get to an important meeting or catch a flight. If you estimated the drive to be half an hour on a good day, perhaps you left yourself an hour to take into account unforeseen traffic along the way.
How about the last time you filled up your car with gas? Did you leave it until you were on the last mile, or did you fill it as the light came on? Do you plug your phone in to charge before it reaches 1%?
Without a margin of safety you are always living on the edge and life is full of stress that doesn’t need to be there.
I listened to a podcast recently with James Clear, author of Atomic Habits. The margin of safety is one of his mental models. Shane Parrish of The Farnham Street blog talks about it in the same way. James describes a margin of safety as a ‘buffer between what you expect to happen and what could happen’.
Look around your community. Someone got cancer when they were horribly young. Someone’s child got sick. Someone had a freak accident. What lesson do we learn when things like this happen to people? James argues the lesson isn’t ‘those things could happen to me’. But instead, the lesson should be, “life is surprising”. He goes on, “if life is surprising, we should have a margin of safety to protect ourselves from the things we cannot predict.”
I talk endlessly about how uncertain life is. We never know what is going to happen next. We have to live with that. What we can do is create a buffer for ourselves which makes navigating the uncertainties easier and less stressful. We can create a margin of safety in any part of our life that involves time, energy, finances or resources of any sort.
Here are five ways that you can build a margin of safety into your financial life:
Cash in the bank. I always recommend maintaining at least six months (three at the very very least) of living expenses in cash. Yes, you give up some growth, but cash is liquid and accessible and the value of it doesn’t change in the short-term. Having access to cash means that when things happen that you are not expecting (the car breaks down, the roof falls in, someone falls sick, you lose your job), you can still pay your bills.
High savings rate. A high savings rate adds an extra margin of safety over just having cash in the bank. Let’s say you earn, for ease of numbers, $200k a year and live on $100k. Now not only do you have $50k stashed away (six months of living expenses) but you also can start compounding your money by investing your $100k savings each year. You are building very solid foundations to withstand almost anything that is thrown at you. If you have a spouse, your ideal margin of safety is to try and live off one income and save the other.
Low fixed expenses. A high savings rate is normally the result of low fixed expenses. This margin of safety is particularly important when transitioning from work to retirement. The more flexibility you have around your spending, the longer your money will last. If you enter retirement with mortgage payments, car loans and school fees to pay each month, you are less able to adapt when market conditions change. If you can scale your spending back five or ten percent during market downturns without it impacting your standard of living, your portfolio will recover more quickly and you will be able to spend more in subsequent years whilst having a higher probability of not running out of money.
Multiple streams of income. Having more than one income stream is a powerful margin of safety. Maybe you have a side hustle, an investment portfolio or a rental property. When something doesn’t go to plan, there is something else to fall back on.
A ‘real’* financial advisor. The most important determinant of your long-term real-life financial success is your own behaviour. A real financial advisor (I use the term real because it has to be someone who is not paid to sell you products) who understands you and understands what is important to you can stand between you and your big mistake (or between you and a series of smaller but compounding mistakes). And as Carl Richards says, “mistakes are part of the game, it’s called being human.” An advisor offers a margin of safety around your ‘human-ness’.
It was Benjamin Graham, Warren Buffett’s teacher, who said “the investor’s chief problem – and even his worst enemy – is likely to be himself.” It was this realisation that led him to construct the concept of a margin of safety in picking stocks. Graham dedicated the last chapter of his famous book ‘The Intelligent Investor”, written in 1949, to this concept. He wrote, ‘the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.’ Or as Warren Buffett once said , “in order to win, you must first survive.”
*a fee only fiduciary advisor.