What is the definition of prudence?To me, it’s “margin of safety.”When you get to the airport early you give yourself a “margin of safety” that prevents you from missing your plane.When you buy life insurance you are providing a financial “margin of safety” for your loved ones. Wearing a motorcycle helmet provides a “margin of safety” between your head and the asphalt.
What Ben Graham meant when he originally coined the term was that making an investment at a discounted price protects the buyer from adverse developments, errors in analysis, and even a certain degree of fraud, essentially Murphy’s Law: if anything can go wrong it will go wrong.For example, you believe a stock is worth $10 and it you have the opportunity to buy it at $5.Even if it turns out the underlying business is truly worth $7, for any of the above listed reasons, a purchase at $5 should still be safe and reasonably rewarding.(You should know that Ben Graham probably would not have considered a helmet enough of a safety margin for riding a motorcycle).
I think that society, as a whole, believes that a safety margin is a good thing.That’s why we have lifeguards, airbags, the FDA, social security, public toilet seat doilies, etc.There is, however, one area in our lives today where the safety margin has been scrapped and that is real estate.
It used to be that a banker’s safety margin was a buyer’s 20% down payment.If a homeowner who had this much equity in the home defaulted the bank could foreclose and likely sell the property to recoup their 80% investment.Today, however, with so many buyers putting 10%, 5% or 0%!!! down on new home purchases this margin of safety has dwindled and in many cases disappeared altogether.
On the other side of the transaction, homebuyers used to have a few safety margins as well.The benefit of a 30-year fixed-rate mortgage is that a homebuyer gets a stable interest rate and builds equity in the property over time.But today most buyers find these attributes unnecessary.Many buyers nationwide and roughly half of the buyer in California are using interest-only, adjustable rate mortgages to be able to afford their purchases.These buyers are essentially “working without a net.” In addition, buyers across the country are now spending more to buy a house relative to their income than any time in history.In other words, buyers have never in history stretched themselves financially more than they are today.Finally, in the good old days when Mom stayed home, homeowners had an additional safety net.If things got bad (read: Dad lost his job) Mom could go to work to help pay the mortgage.With so few stay-at-home moms today (I believe the term, “Unemployed mom,” is an oxymoron), homeowners lack even this fail-safe.
So what’s the big deal? Well, I’ve got Murphy on one shoulder, Ben Graham on the other and mixed metaphors in between. Can you picture a bunch of heltmetless, motorcycle-riding homeowners late for the airport?