How to Minimize the Cost of Your Bad Financial Assumptions

How often do you make mistakes? Well, “the intelligent investor must focus not just on getting the analysis right. You must also ensure against loss if your analysis turns out to be wrong,” says Jason Zweig, Wall Street Journal columnist and author of Your Money and Your Brain. How can you guard against your own goofs?

Over the last several years, we saw record home foreclosures across the country. You might argue (convincingly) that lenders had no business greenlighting some of the mortgages leading up to the mess. Yet homebuyers bear as much responsibility for choosing to acquire such a nearly fully leveraged asset – and, more importantly, a liability – that provided no margin of financial safety.

Benjamin Graham and David Dodd coined “margin of safety” in their 1934 book Security Analysis; Graham further emphasized the phrase in his 1976 book, The Intelligent Investor, which Wall Street guru Warren Buffett called “by far the best book on investing ever written.” Such margins make good investing precautions.

The above-mentioned homeowners, for instance, signed on for these homes (not to mention second and third ones) undeniably based on a wide range of assumptions: home prices will always increase; cash flow and tax rates will remain the same; and these homeowners will not suffer such surprise expenses as medical costs or home or car repairs. The list goes on.

With no margin of safety to buffer against even one of these assumptions going sour, many had no chance of hanging on against the eventual housing storm.

In his white paper “The Seven Immutable Laws of Investing,” James Montier argues that “valuation is the closest thing to the law of gravity that we have in finance … the objective of investment [in general] is not to buy at a fair value, but to purchase with a margin of safety.”

In other words, buying stock of a great company or index does not always mean you made a great investment – the price matters. The same given stock can be a great investment at one price and a bad investment at another.

Source: Thinkstock

Source: Thinkstock

Graham points out that a margin of safety has less to do with maximizing return and more to do with insulating yourself against miscalculation or incorrect assumptions. Think of the early 2000s, when investors couldn’t get enough of soon-to-burst tech companies at high prices that offered no such margin.

This same principle holds in financial planning. Our investing and financial decisions rely heavily on conscious and unconscious assumptions. Whether you forecast weather, speculate on the price of gold or try to predict a pro sports playoff game, you use a lot of assumptions to draw your conclusion.

To illustrate the big role assumptions play in our financial lives, consider that the difference between earning 8% per year on a $100,000 portfolio over 30 years and earning 6% on that same portfolio is a whopping $525,000. Instinctively, we immediately blame only poor investment performance for the difference.

In reality, that difference may result from a range of unpredictable factors out of your control: a worsening economy over three decades, adverse changes to the tax code, prolonged high inflation, currency debasement or wars, to name a few. The difference may also stem from factors you can control, such as a miscalculation, buying and selling investments at the wrong time or changing your savings and spending habits.

Always insist on a margin of safety. This is not meant to restrain you from living life to the fullest today but does aim to encourage you to be honest when you assess how much house or new car you can afford or how secure you are in your current job. Your assumptions may be wrong – be ready to realistically look at risks to your financial life and adjust your lifestyle.

In both investing and financial planning, it’s better to be approximately right than precisely wrong.

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Joe Pitzl, CFP, is the managing partner at Pitzl Financial in Arden Hills, Minn. He writes for the blogs Beyond the Money and Financial Fairway. Follow Joe on Twitter at @joepitzl.

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