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Margin of Safety

October 1, 2025

“You have to plan on your plan not going according to plan.”
- Morgan Housel

In a recent discussion with a client regarding a future cash flow analysis I’d completed for him, the client asked, “If a portfolio like mine has averaged a 9% annual return the last 20 years, why are you using 5%?” I suspect underlying this question was another unspoken question - did I know something he didn’t about future markets? Or perhaps it was a simple, straightforward question - why didn’t the estimated return in this analysis remotely resemble historical returns of comparable portfolios?

The answer, and an essential element to any financial planning topic, is the ever-important element of leaving room for error, or “a margin of safety,” as economist Benjamin Graham calls it. When it comes to building a margin of safety with future rates of return, there is no hard and fast rule. Commonly, financial planners will take the average rate of return for the last 50 years for a particular allocation and reduce it by a third as a prudent figure for calculations.¹

In his behavioral finance book, “The Psychology of Money,” Morgan Housel highlights how investing is not a game of certainties. To be effective, a good investor requires humility - an understanding that we don’t know and can’t know how the future will play out, regardless of historical results. As Morgan writes, “You have to plan on your plan not going according to plan.”²

This is counter-culture. We live in a world where certainty is king and people love speaking in absolutes, especially in finance. Stock analysts give price targets, not price ranges; economic forecasters predict precise figures. Unfortunately, we tend to give ear to people who speak in certainties, more than the person who says, “We can’t know for sure” and speaks in terms of probabilities.

Housel writes, “The best we can do is think about odds…and tilting the odds in our favor. Pursuing things where a range of potential outcomes is acceptable, is the smart way to proceed.” More specifically, building capacity for a range of possibilities might include underestimating annual rates of return on your investments, overestimating what you need to save for retirement and tightening the belt on expenses from time to time.

This may seem like an overly conservative approach, but when done correctly, leaving room for error actually has the opposite result - it allows you to stay in the game longer and endure tough times when they inevitably occur. For example, many people overestimate their ability to endure market volatility. In theory or on a spreadsheet, they might be okay with 30% loss, but they overlook the emotional toll of such a substantial loss and misjudge how they’ll respond. Over the years, many eager investors have sold out of their investments as they hit rock bottom because they couldn’t take the stress. By assuming your risk tolerance is a little lower than you think, and building your portfolio accordingly, you are increasing your chances of hanging in there when times are tough, which puts you in the best position for reaping long-term rewards.

- Carrie McDonnell

1. NOTE: Don’t forget inflation! When you compound growth, even a modest amount of growth, over decades, the numbers have a way of looking dazzlingly good, but keep in mind those numbers need to be tempered by inflation. For example, $1,000,000 adjusted for inflation at 2.16%/year for 20 years is $656,567 in 2025 dollars.
2. “The Psychology of Money: Timeless lessons on wealth, greed and happiness.” 2020. By Morgan Housel.