Page 136 - Psychology of Money - Timeless Lessons on Wealth, Greed, and Happiness-Harriman House Limited (2020)

Benjamin Graham is known for his concept of margin of safety. He wrote
about it extensively and in mathematical detail. But my favorite summary
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of the theory came when he mentioned in an interview that “the purpose of

the margin of safety is to render the forecast unnecessary.”

It’s hard to overstate how much power lies in that simple statement.

Margin of safety—you can also call it room for error or redundancy—is the
only effective way to safely navigate a world that is governed by odds, not
certainties. And almost everything related to money exists in that kind of
world.

Forecasting with precision is hard. This is obvious to the card counter,
because no one could possibly know where a particular card lies in a
shuffled deck. It’s less obvious to someone asking, “What will the average
annual return of the stock market be over the next 10 years?” or “On what

date will I be able to retire?” But they are fundamentally the same. The best
we can do is think about odds.

Graham’s margin of safety is a simple suggestion that we don’t need to
view the world in front of us as black or white, predictable or a crapshoot.
The grey area—pursuing things where a range of potential outcomes are
acceptable—is the smart way to proceed.

But people underestimate the need for room for error in almost everything

they do that involves money. Stock analysts give their clients price targets,
not price ranges. Economic forecasters predict things with precise figures;
rarely broad probabilities. The pundit who speaks in unshakable certainties
will gain a larger following than the one who says “We can’t know for
sure,” and speaks in probabilities.⁴²

We do this in all kinds of financial endeavors, especially those related to our
own decisions. Harvard psychologist Max Bazerman once showed that
when analyzing other people’s home renovation plans, most people estimate

the project will run between 25% and 50% over budget.⁴³ But when it
comes to their own projects, people estimate that renovations will be
completed on time and at budget. Oh, the eventual disappointment.