Wednesday, March 21, 2007

Maintaining A Margin of Safety

One of the best principles I have learned in personal finance is to use the concept of a "margin of safety." This principle has been and will be a great help when it is needed. What, one might ask, is a "margin of safety?"

For me, a margin a safety is "additional protection" that one creates to insure against over estimating the value or against an unexpected issue. The opposite of margin of safety is "living at the edge," which is where a single financial problem would cause significant issues.

Here are some examples:

Total Debt. A typical guideline financial instituions use is that total debt payments (mortgage with taxes and insurance, car loan, credit card, student loan, etc.) should be no more that 36% of gross income.

I currently have a significant margin of safety with my current home mortgage, which is our only debt. Our down payment was 43% of the house price. Our mortgage payment (including taxes and insurance) is 19% of my gross salary, which leaves a 17% margin of safety for our total debt. If housing prices should decline or there is a short term financial issue, we should be able to handle it.

For my first house, I only put down 20% and my mortgage payment was 25% of my gross pay. My other debt was a student loan and a car loan, which were 3% and 8% for my gross income. So debt accounted for 36% of my income, and had no margin of safety.

I have recently read that some people have mortgage payments that are 40-50% of their gross income. To me, this is past living at the edge.

Auctions. I periodically attend auctions because I like to get good deals:-) Occasionally, I have seen bidders get caught up in the excitement and bid 10% or more over the market value. In the worst case, they pay more than it would have cost in a store.

A key to getting a good deal is to make a good estimate of the value of an item before the bidding starts. However, since I am not an expert appraiser for most items, there is a chance that I will over estimate the true value. Therefore, after I make an estimate, I reduce it by 30-50% and set that number as my top price. The 30-50% reduction is my margin of safety.

Real Estate - My experience with real estate has primarily been with purchasing our home. I have done this twice and my strategy has been to buy "the lowest" priced house in an excellent neighborhood. This approach offers some margin of safety against over paying. Also, I avoid getting into bidding wars with other buyers or bidding over the asking price. When this happens, I know the market dynamics has eliminated the margin of safety.

I have owned investment real estate with my father. I have also periodically looked at purchasing investment real estate on my own. My margin of safety is to look for properties in good neighborhoods that have positive cash flow (i.e. make money) at a low down payment and before tax deductions. Another margin of safety is to buy a property with a long term lease tenant. So far, I have not been able to find any investment real estate that meet my requirements.

Stock Investments. While many advisors would disagree, my margin of safety is to maintain a fairly large cash balance (about 25%) in my personal accounts. Having this margin of safety helps me sleep at nights when the market is volatile. To note, keeping this level of cash reduced my gains in the late 90s. However, having 50% cash in my personal accounts significantly reduced my level of losses in the 2002 bear market.

In addition, I do not use margin (i.e. borrowing money) for stock investments. For me, using margin would be close to living at the edge:-)

I wish I was better at estimating a margin of safety for individual stocks. As I wrote in an earlier post, I still am not very good at successfully identifying value stocks.

For more on The Practice of Personal Finance , check back every Wednesday for a new segment.

Photo Credit: morgueFile.com, Anita Patterson Peppers

This is not financial advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC

2 comments:

moneymonk said...

I do agree margin is the worth move.

BTW, Is that your daughter? she is adorable

Super Saver said...

Moneymonk,

Although our daughter is equally adorable, it is not a picture of her. The majority of the photographs I use are from morgueFile.com, which provides an excellent library of royalty free pictures to use.