Margin of safety and the principle of diversification.

1. There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other.
2. Even with a margin in the investor’s favour, 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.
3. 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.
4. Diversification is an established tenent of conservative investment.
5. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion.
6. This point may be made more colourful 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. (In “American” roulette, most wheels include 0 and 00 along with numbers 1 through 36, for a total of 38 slots.)
• 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.
• But suppose the winner received $39 profit instead of $35.
• Then he would have a small but important margin of safety. Therefore, the more numbers he wagers on, the better his chances 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.)

Ref: Intelligent Investor by Benjamin Graham