Having a Margin of Safety Works for Your Whole Financial Life

November 9, 2017

Famed investor Warren Buffett once stated that “margin of safety” are the three most important words for investing.  By this, Buffett sought to illustrate the idea that If you make your investment too close to the line (or the proverbial edge of the roadway cliff),of succeeding or not, the risk of falling off might be more than you realize.  Buffett was naturally referring to margins of safety with investing, but the concept also applies to many areas of personal finance.  Having such buffers in your financial plan is prudent and can help avoid that “one thing” in life that sets you back in a big way.

For most people, everyday spending is often the first danger area.  Too many consumers are living paycheck to paycheck.  The personal finance site “MarketWatch” reported earlier this year that 19% of American households had zero- nothing - nada in emergency savings and 31% of households have less than $500 to pay for things like car repairs, home emergencies, medical co-pays and deductibles, living expenses in case of a job loss, etc.   When difficulty strikes in your life, having that cash cushion can be like a warm blanket on a cold winter night, despite the fact that cash doesn’t earn much nowadays. 

Similarly, another problem area is credit card debt.  Now that we’re three quarters of the way through the year, take a look at your credit card statements for the past 9 months.  If your balance(s) are creeping up, you might consider some serious spending changes, especially since we’re not even into the holiday season yet.  A steadily increasing credit balance may mean you have no margin of safety in your income versus spending habits.

Retirement planning is another area where retirees and pre-retirees might employ some margin of safety concepts.  There are many assumed variables that go into a retirement income analysis, including investment return, inflation and tax rates.  I’ve seen some reports where average rates of return seem a little high, (considering market valuations, potential interest rate increases and moderate economic growth for the US).  In fact, some of these results haven’t factored in the “What Could Go Wrong?” factor into the analysis.  Banking on all being well in the financial world in the next decade or two could be hazardous – if history is any guide.  Having your retirement income needs based upon all-is rosy scenarios may not be a wise idea.

Permanent insurance policy projections (for those policies that build cash-value) could be another problem area if the policy owner is expecting to tap the cash value for retirement purposes.  Oftentimes, projections of return are a bit optimistic and purchasers forget to look closely at the “non-guaranteed” heading on these projections.  Similarly public and private pension overseers could use a bit of margin-of-safety thinking when considering how underfunded their pension plans are and the rate of return they’re using in their assumptions.  As many observers have pointed out, overly optimistic return projections are just kicking the can down the road for hard choices that ought to be made to keep the plan whole for the future.

In summary, safety “buffers” are prudent and worth having in all areas of your finances.