By Dan Ferris in Extreme Value:

Without a doubt, though, the single most important investment concept I've picked up over the years is Benjamin Graham's "margin of safety" principle, spelled out in Chapter 20 of The Intelligent Investor. I read this chapter once a month and recommend you do the same.

Graham's margin of safety concept teaches you to pay less than intrinsic value for all of your investments. There's a powerful implication there: If you don't know the intrinsic value of the investment, you can't possibly invest safely. Everything I do in Extreme Value is based on my own estimates of each business' intrinsic value.

The margin of safety principle also teaches you that, when stock prices fall, they become safer investments. This is contrary to the powerful emotional reaction most investors feel when they see a loss on their brokerage statement, i.e., that their portfolio is suddenly more risky.

It's hard to find an investor who buys a stock at $10 because he thinks it's worth $20 and doesn't feel like he's made a big mistake when it drops to $6... even though his risk exposure has decreased and his upside has increased.

To be more accurate, it's hard to find anyone who buys a stock based upon a well-reasoned estimate of its intrinsic value. Most people buy because they believe a hyped-up story that's going to push a stock up quickly, even though it's impossible to predict near-term stock price movements with enough consistency to make a business out of it.

When such speculators (gamblers, really) buy a stock and it falls, they perceive more risk, the exact opposite of what the value investor sees: a greater margin of safety (provided the intrinsic value hasn't fallen by exactly the same amount as the stock price).

The breakthrough of margin of safety is that lower risk means bigger upside. Most people think big upside means big risk. If that were true, risk and reward would cancel each other out, leaving you with no benefit after a lifetime of investing. Margin of safety teaches investors that only by reducing risk can they tip the reward side of the scale in their favor.

Crux Note: Dan Ferris is the editor of Extreme Value. For serious investors, Extreme Value is one of the best advisories you can buy at any price. If you're not already a subscriber, you owe it to yourself to learn more here.

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