Warren Buffett said the three most important words in investing are "Margin of Safety."

He also said that Chapter 20 of The Intelligent Investor is the best chapter ever written on that topic.

Here's what Chapter 20 taught about the Margin of Safety

1. The Concept of a Margin of Safety
A stock has a fair (intrinsic) value based on the underlying company.
This fair value often deviates from the stock price by a wide margin.
No Margin of Safety: Stock Price > Fair Value
Margin of Safety: Stock Price < Fair Value

2. Benefits
Buying something for less than it's worth is always a good deal.
In investing, its importance is even greater because you never know the exact fair value.
You can only guess a range.
A Margin of safety is self-defense against a wrong estimate of fair value.

3. The Mathematical Advantage
A MoS offers two mathematical advantages.
First, downside protection. It takes a 100% gain to recover a 50% loss.
So not losing money should be your priority.

Second, exponential returns.
Stock A is worth (fair value) $10 but is selling for $8. Upside=25%
Now, if that same stock weren’t selling for $8 but for $5, the upside potential would suddenly become 100%.
So, a MoS prevents unrecoverable losses and exponential returns.

4. Why do Margins of Safety exist?
Benjamin Graham introduced Mr. Market.
An impulsive person. Sometimes depressed (selling stocks cheap), sometimes exuberant (selling expensive).
Our stock markets work like that because of the psychological errors of market participants.