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Why it’s important to build a margin of safety into your investment strategy

The human brain is powerful but subject to limitations. For this reason, we have evolved to have a collection of cognitive biases. These are systematic errors in thinking that occur when you process and interpret information around you, and it can affect the decisions and judgments that you make.

One of these biases is overconfidence. This is the tendency to be more confident in your own abilities than is objectively reasonable.

The best-known examples of this are the multiple studies in which a majority of respondents believe themselves to be above-average drivers.

Financial planning requires several assumptions to be made before any useful projections and analysis can be done, and these inform the decisions that could affect you for decades to come.

As a result, you mustn’t allow your own overconfidence, or that of the professionals you engage in the process, to jeopardise your family’s future.

A range of variables could affect your investment plans

In the financial world, the term “margin of safety” is often associated with Warren Buffett, who tries to purchase stocks well below his estimate of their true value. This allows him to be wrong without incurring major losses. It’s a sign of humility, acknowledging that there is so much we do not know.

You will benefit greatly from building in a similar “room for error” into your own financial projections, because there are a range of variables including:

  • The rate of inflation
  • The returns on your investments
  • Your outgoings in retirement
  • Your life expectancy
  • Future healthcare costs.

As an investor, acting alone or with the help of a financial planner, you could be tempted to make optimistic assumptions for each of these variables, knowing that it will make your current position look better. On the one hand, this could save you from needing to confront any financial weaknesses that you may know exist.

However, while assuming that recent inflation rates and investment returns will continue forever will make you feel better about your future prospects, it may also lead to you making decisions in the present that your future self will regret.

You can take practical steps to build a margin of safety for yourself

Having more realistic expectations will give you the opportunity to make the required changes to your situation before it’s too late.

If you are still in the saving stage you will be able to ensure that you make full use of your savings window. If you have already retired, you will have time to make adjustments to your withdrawals and spending before you risk outliving your money.

Your investment return assumptions can be based on long-term historical returns of different investment cycles, rather than the latest decade of great returns. You could even reduce this slightly to allow for any extended periods of lower returns, compensating by saving more or spending less.

Inflation rate assumptions can be based on long-term averages, which will immediately highlight that recent years of low inflation are not the norm in most countries. This will show the need to allocate investments to assets that have the potential to grow in excess of this number.

Your future spending needs should be based on a realistic picture of what daily life might look like, and take into account additional expenses that you hope won’t be payable.

Similarly, you need to consider the increasing life expectancy for people who are well-educated and have access to quality medical care. Your memory of your grandparents may not be helpful when guessing how long you could live.

It’s important for you to have realistic expectations

While it’s advisable to be realistic, it’s also important not to be overly pessimistic. This will only serve to make you feel that it’s not worth doing much because no action will make your future look exciting.

My job is to help you make informed decisions based on realistic expectations. Through working with other clients, I know what is realistic and reasonable.

My recommendation is to build in a margin of safety so that you do not need the perfect combination of factors to get you to a dignified and independent future. You do not know what the future holds but, with a margin of safety, you don’t need to.

Get in touch

If you’d like to talk through your own investment arrangements and create a margin of safety for yourself, then please get in touch.

You can call me on 07769 156 250.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Equity investments do not afford the same capital security as deposit accounts.