Margin of Safety, or why you should always save for a rainy day

[Note: I shared this mental model with my email subscribers on Feb 12, 2017. If you want to receive a new mental model every week, join the club.]

Margin of Safety: You build a bridge that 30,000-pound trucks can go across, and then you drive 10,000-pound trucks across it.

What it is:

Margin of safety is a critical principle in engineering.

Let’s say we’re building a bridge, and the maximum weight of vehicles we expect on the bridge is 5,000 tons. So do we build it to withstand 5,000 tons? 6,000 tons?

No. We build it to withstand 20,000 tons. That’s the margin of safety.

When you save “for a rainy day”, that’s what you’re doing. Building a contingency fund. A margin of safety for your lifestyle, should you lose your job.

As Seth Godin explains in Breakpoints: when laying a sidewalk, workmen don’t put long slabs of concrete in place. Instead, they keep small gaps every few feet. That’s a margin of safety too – in case the concrete breaks or expands in unpredictable ways.

Examples from business:

  • Investing: Margin of safety is a core tenet of value investing, popularized by Benjamin Graham and David Dodd. As Warren Buffett, a long-time protege of Ben Graham, says: “If we calculate the value of a stock to be only slightly higher than the price, we’re not interested.”
  • Startup fundraising: You don’t raise just enough capital to get to your next round of funding. If you want to raise your next round at $1Mn in revenue, raise enough now to get to $2Mn. Better still, raise enough to become profitable. Similarly, don’t start looking for investors when you have one month of cash in the bank. Start when you have six.
  • Capacity planning: Most services organizations keep a bench (idle employees) of up to 20% of their total headcount. So that they can service any sudden requirements. Same goes for manufacturing – as they say, if you have 20% spare capacity, you have no spare capacity.
  • Project planning: When drawing out a project plan, always put in a few buffer days / weeks.
[Aside: we almost never do this. There’s even a name for it. The planning fallacy – how we believe that this time, unlike all previous times, we’ll finish the project on time.]

Rules to follow:

  1. Always build a margin of safety. Whatever you’re doing, estimate how long, how much money, etc. it’ll take. Then add a buffer.
  2. Expect your plans to go awry. Do a premortem. And then build redundancy / backups.

As Seth Godin says in the article above, there’s no doubt the ground will shift. The question is: when it does, will you be ready?

Further Reading:

 

Linked to: Redundancy, Premortem

Filed Under: Engineering

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