I’ve been re-reading a few investment classics lately. A concept that struck me recently was the “margin of safety” discussed in The Intelligent Investor. (The Intelligent Investor was Benjamin Graham’s slightly simplified version of his approach to securities analysis for individuals.) In fact, Graham claimed that the margin of safety was the essential message of his entire approach to investing:
Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.
For Graham, the margin of safety might be in the interest coverage ratio for a bond, or in the projected earnings growth rate for a common stock. The idea is that even if the investment does not meet your projection, you have ample room for error and are still likely to come out okay. Hence, you have a margin of safety.
Margin of safety was the first thing that occurred to me when I read a Wall Street Journal article over the weekend entitled Retiring Boomers Find 401(k) Plans Fall Short. (This morning the article also ran on MarketWatch.) As the article points out, 401(k) plans first came into wide use in the 1980s, so the leading edge of the baby boomers now retiring are the first group to have the accounts form the backbone of their retirement savings. The situation is not encouraging:
The median household headed by a person aged 60 to 62 with a 401(k) account has less than one-quarter of what is needed in that account to maintain its standard of living in retirement, according to data compiled by the Federal Reserve and analyzed by the Center for Retirement Research at Boston College for The Wall Street Journal.
How in the heck do you end up 75% short of the savings needed to maintain your standard of living? Answer: no margin of safety.
Think about it—if you are doing things prudently, you should have a margin of safety. You need to over-save in case something goes wrong. Which, inevitably, it will. Trust me on this: unexpected expenses are way, way more common than unexpected windfalls! If you have a margin of safety in your savings, the worst case scenario is that you will have too much money saved for your retirement. Is that really a problem? Have you heard more retirees complaining that 1) they can’t get a first-class cabin on a last-minute Caribbean cruise, or 2) they were planning to travel in retirement but now they can’t afford to?
401(k) providers are slowly catching on. According to the article, Vanguard recently suggested saving 12-15% of their income, versus the 9-12% recommendation earlier. In Andy’s short course in financial planning, we recommended that a minimum of 15% of income should be saved.
I think it is worthwhile to show clients the article. It is a litany of undersaving and/or things going wrong, sometimes at the worst possible time. (When else do things ever go wrong?) In each case cited in the article, the retirees were up against it because they had no margin of safety. Frankly, many clients are worse off than some of the retirees mentioned in the article. As an advisor, it’s your job to help people make intelligent financial decisions, especially those they will find difficult to make on their own. Convincing them to save with a margin of safety might just be the most important thing you will ever do for them.
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