Why Value Investing?

Once you enter the wormhole of options, you enter a different galaxy of possibilities.

With stocks, you buy, sell, or hold the underlying security. With options, just learning the colorful terminology of the standard option strategies takes a while.

The more I learn about them, however, the more I understand why I find plain value investing appealing. Here is a partial list of reasons:

Alignment

I find that my personality and lifestyle are aligned with the philosophy and practice of value investing. By this I mean a whole bunch of things.

I enjoy learning about companies. This curiosity increases my engagement with the world around me. I used to do this even before I had any interest in businesses or investing. Now, I simply use a different lens.

I like to think I have the right temperament. I may be deluding myself. But being disciplined, conservative, and contrarian comes somewhat easily to me. History provides some external validation for this claim; during both the recessions I have been through (2000 and 2008), I ploughed in nearly all my discretionary capital into the market. Over the last few years, as the market has embarked on its fast and furious ascent, I have been reluctantly liquidating my holdings, and increasing my cash position (now at >35%!).

I have a full-time job that I enjoy; I cannot devote more than an hour of time everyday monitoring positions, and plotting schemes. The low-frequency and low-maintenance aspect of value investing is aligned with my schedule and life-style.

Scalability

I am happy with a compounding rate of 10-15%. I want a formula that lets me do that relatively consistently over the long-term. I want to be tethered to a core philosophy and process that will scale gracefully as the amount of capital being managed increases.

Is that asking for too much? 🙂 Many in options world might think, I am asking for too little!

It is clear that many option strategies occasionally yield extraordinary returns on investment, especially when you annualize them. If you buy a call option, and the price goes up by 10% in 10 days (a rather commonplace occurrence), your annualized return on that investment is over 3000%!

If I have $10,000, I would end up with a profit of $1,000. But the key question is, would I do it as the stakes got higher? Would I stick $10,000 into the same bet if it had, say a greater than 10% chance of expiring worthless (again a rather commonplace occurence).

Probably not.

And what if I had to manage an all-option $1M portfolio? I am not sure if I would die of hypertension, or go broke, first.

I know some skilled traders do it. I know I can’t. And I am not interested in the game.

One appealing feature of simply buying good companies at a bargain and holding them for a long time is that the process is completely scalable.

You can stick to the same process regardless of whether your portfolio size is $100,000 or $1 billion.

Structurally Advantaged

In economics and finance, if a good strategy becomes widely known, it generally stops working. Information has a way of getting arbitraged away. This is why I think the efficient market hypothesis is, by and large, a decent model, despite the bad name it gets in value investing circles.

Most liquid securities are “fairly” priced, most of the time. This is also why most individuals should just index.

However, there are behavioral reasons why value investing continues to work. It works because we are humans.

Because we are a big organic ball of greed and fear with a tiny microprocessor attached, masquerading as a rational animal.

When we look at things that make us go “yuck!”, the natural response is revulsion. When everything around us is crumbling, our instinct is to run for safety, not look for sweet bargains. When the party is going great, nobody wants to leave early.

Knowledge of these biases is not enough to overcome them. Knowledge is a necessary condition; it is not sufficient.

There are tax advantages to value investing over options investing, which generally tends to be short-term. Holding good to great companies for a long time, we can let compounding really do its number. Short-term taxes can be a big drag on returns. As portfolio size grows, this can lead to inconvenient and unexpected tax bills.

There are also institutional reasons why value investing is structurally advantaged. Most money managers are lucky if their performance is measured on an yearly basis (usually it is on even shorter timescales). They might have far more resources and intelligence than you and me, but they have constraints (like size, mandate, and time horizons) that we are unfettered by.

If you have a 20%/year idea that will take 5 years to fully play out, you can take that bet. The money manager probably can’t.

Time arbitrage and freedom from yearly comparisons with a index are two of the biggest structural advantages that we small value investors have over professional money mangers.

 

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