Magin

You've all heard stories about professional investors underperforming index funds, but economists Ron Acquits, Lutz Kilian, and Robert Vigfusson took this humiliation to the next level. The trio showed that forecasts of the price of oil one year out made by the Energy Information Agency and survey firm Consensus Economics were no more accurate than just assuming whatever oil's price is today is what it will be next year. Literally, not having any forecast was as accurate as a professional forecast.

What is true for oil is undoubtedly true for economic growth, corporate earnings and industry trends. Most of us can't stand the thought of it, but anyone looking honestly at the evidence knows we are spectacularly awful at predicting the future.  

This might seem disturbing to investors. How do you invest in the future while holding a nearly fatalist view that we can't predict the future?

Luckily, the world's smartest investment minds came up with an answer, and it might contain the three most important words in investing. It's called the margin of safety.

Margin of safety is simply the distance between your predictions coming true and needing those predictions to come true. You can still try to predict the future, but a margin of safety gives you room for error to be wrong.

Benjamin Graham summed it up when he said, "The purpose of the margin of safety is to render the forecast unnecessary."

You don't want to buy a stock you think could grow earnings at 10% a year but needs to in order to make it a good investment. You want to buy the stock that could grow earnings at 10% a year but would still make a decent investment if it only grows earnings by 5%, or 2%, with anything beyond that being cream cheese.

Take this example from Warren Buffett biographer Alice Schroeder. Schroeder describes how Buffett analyzed a stock he purchased in the 1960s in a company called Data Documents. Rather than forecasting what the company might earn in the future, Buffett looked at the company's current figures and asked if he could get a good return even if they deteriorated. "There was a big margin of safety built into these numbers," Schroeder says. The company "had a 36% profit margin. [Buffett] said, 'I'll take half that.'"

In the end, Data Documents did fantastic, and Buffett made a fortune, but that's not what's important. What made the company a great investment is that it didn't need to do fantastic for Buffett to still have done all right. Heads he won, tails he did OK.

The whole concept of margin of safety is possible because there's a difference between the price of a stock and the value of a company. It pops up when you don't have to pay a high price for the possibility of good news, or when possible bad news is already priced in. This what Graham meant when he wrote: "The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price."

Think about the S&P 500 (SNPINDEX:^GSPC) two years ago. Analysts fought back and forth trying to guess how much corporate profits would grow. Some said earnings would grow a lot, others said a little, others predicted a small drop. But from an investing standpoint, it almost didn't matter. The index traded at less than 12 times earnings.  At that level, stocks could have been a decent investment even if earnings hadn't grown at all. You didn't need good news to pan out. There was a margin of safety.

This goes beyond stock-picking. Those who save the exact amount of money they think they'll need to retire are one bear market, hospital visit, or divorce away from trouble. Anyone who thinks they have ultimate job security, or don't need to save because they have an inheritance coming, or think they can handle a lot of debt because a Christmas bonus awaits will eventually learn that the quote, "You plan, God laughs," can be painfully true.

You're going to be wrong a lot. It's part of investing, and it's part of life. Insisting on having a wide gap between what you think will happen and what could happen if you're wrong is the only way to hedge against it.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

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