The Margin of Safety

One thing that volatile markets teach you is discipline.  If they don’t, you won’t be playing in them very long.  I have been reading some of legendary investor Charlie Munger’s wisdom lately.  I really like the way he approaches investing.   They assume a lot of risk, but it’s always calculated and measured.  At Berkshire, unlike VC funds, they don’t have the pressure of “putting capital to work” and management fees.  They can take their time and wait for the one.

To understand the margin of safety, it helps to understand statistics and probability.  Variance and standard deviation are integral pieces to understanding the margin of safety.  Conditional probability and Bayesian statistics rule in every decision.  I don’t think a lot of people truly understand statistics these days.  Most of the public statistics put out by various organizations are designed to support a point of view, not to help you objectively analyze an issue.

One of the things that Munger talks about is “the margin of safety”.  He says, “No matter how wonderful [a business] is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.”

That means buying it right.  The normal vicissitudes of life are longer than the next ten minutes, or next year.  It’s a long time horizon.   In venture, the norm is becoming 10 years or longer.  Of course, with a change in government policy and a change in market conditions the hold period might change too.

Munger believes that you have to have a lot of process around investing.  It helps to think like an engineer; not necessarily an accountant.  Engineers factor in a lot of margin of safety when they build projects like bridges or buildings.  He says, “In engineering, people have a big margin of safety. But in the financial world, people don’t give a damn about safety. They let it balloon and balloon and balloon. It’s aided by false accounting.”  If you have ever taken an accounting course, the one thing you should learn from it is the numbers are just a point of view, a presentation of the business.  It might not be how the actual business runs and it might not be the true value of the business.

One of the tough things about the venture business is having a disciplined process around investing and valuation.  The “market” has often set the valuation in the past several years.  Seed stage valuations have ballooned.  Having the discipline to walk away shows you understand the margin of safety.

One good outcome to the Fed raising interest rates, the ICO crash, and stock market volatility is that seed stage valuations should come down.