There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other.
- Even with a margin in the investor’s favor, an individual security may work out badly.
- For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible.
- But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.
- That is the simple basis of the insurance-underwriting business.
Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion.
This point may be made more colorful by a reference to the arithmetic of roulette.
If a man bets $1 on a single number, he is paid $35 profit when he wins—but the chances are 37 to 1 that he will lose.
- He has a “negative margin of safety.”
- In his case diversification is foolish. The more numbers he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel.
- Then he would have a small but important margin of safety.
- Therefore, the more numbers he wagers on, the better his chance of gain. And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers.
- (Incidentally, the two examples given actually describe the respective positions of the player and proprietor of a wheel with 0 and 00.)*
- Just as it is in the roulette player’s interest to bet as seldom as possible, it is in the casino’s interest to keep the roulette wheel spinning.
- Likewise, the intelligent investor should seek to maximize the number of holdings that offer “a better chance for profit than for loss.”
- For most investors, diversification is the simplest and cheapest way to widen your margin of safety.