A margin of safety exists when a security is trading at a discount to its intrinsic value. Margin of safety brings up the relationship of price vs value. Anything can be a good deal at the right price, and anything can be a bad deal at the wrong price.
‘Price is what you pay, value is what you get.’
– Philip Fischer
If your friend had a $10 bill and offered to sell it to you for $8 you would take the offer and receive a nice $2 profit. $2 is the margin of safety here. Now if he offered you $12, you’d tell him he was crazy, and that there is no way you’re paying $12 for a $10 bill.
The price is changing in this situation, and the value $10, is staying the same. Now no one is ever going to give you a $10 bill for $8 because everyone knows the $10 bill is worth $10 in this situation. Not so in the stock market, things are mispriced, both higher and lower because valuing these businesses is no easy task.
Mispricing also comes in the form of emotion, too much optimism or pessimism can influence a stock and carry it far away from its intrinsic value.
“in the short run, the market is a voting machine but in the long run, it is a weighing machine.”
– Warren Buffett
This is where psychological discipline and awareness step in, and it is necessary to succeed in the market.
