Ben Graham, Margin of Safety

"If you were to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.” — Benjamin Graham

When Ben Graham wrote "The Intelligent Investor", he saved the most important chapter for last; Chapter 20 of the investment classic directly addresses the concept known as margin of safety. I consider the last chapter of the book to be the single most important piece ever written about value investment philosophy.

So what exactly does Chapter 20 tell us about risk? After all, the concept of margin of safety is directly related to risk since the primary focus of all successful value investors is to minimize downside risk while being able to fully participate in upside market potential.

According to Graham: "Observation over many years has taught us that the chief losses to investors come for the purchase of low-quality securities at times of favorable business conditions."

Without question, the most common blunder investors make is failing to realize that the earnings power of a business is frequently temporary in nature. More specifically, the cyclical nature of earnings is generally under estimated and the duration of the competitive advantage of a business is frequently over estimated. In such cases, the trailing price to earnings ratio presents investors with a mirage rather than a margin of safety.