Value Investing Is the Best Investing Strategy, Term Paper Example

In finance, there is a basic concept of positive relationship between risk and return which explains why investors usually expect higher returns from stocks than bonds. This may also explain why individuals are advised to focus more on stocks in their investment portfolio while they are still young and retirement is decades away. But sometimes there are exceptions to rules and value investing may also be the exception to the rule of direct relationship between risk and return.

Value investing results in higher returns over the long term despite lower risk because value investors invest in companies they truly understand and know the markets will eventually realize the company’s actual worth. They stay away from the companies they do not understand because they understand their own expertise and stay within its limits. This explains why Warren Buffet stayed away from internet stocks while everyone was joining the party because Warren Buffet didn’t really understand technology stocks. How value investors are able to earn higher returns despite taking lower risk is best explained by the most successful value investor of our times Warren Buffet, “Risk comes from not knowing what you are doing.” (Tier, 2013).

Value investing rejects the notion that investing should be like fast-paced sports with good investors hitting home runs year after year and entering and exiting equity positions all the time. Instead, value investing treats investing as marathon in which the long-term results matter more than the short-term results. To them, the frequency of entering new positions or exiting old positions doesn’t matter because they are only concerned with buying low and selling high. Thus, one can say one of the most important characteristics required of value investors is patience. Since they are willing to wait as long as it takes, they are able to score superior returns with less effort. Value investors understand superior returns require not working harder and frequent trading but working smarter. This explains why value investors are currently shunning the stock market even though market has significantly recovered from 2009 level. Even the economy is showing signs of recovery and the mood is optimistic. But value investors are choosing not to invest in the market now because the timing is not right even if it means huge cash reserves. For example, Vito Maida of Patient Capital Management believes new accounts should have 75 percent in cash and another money manager Lonnie Rush also advises keeping 70 percent in cash (Rothery, 2014). It is clear value investors display high levels of patience to make sure their timing of purchase and selling is right no matter how long it takes.

Value investors are also not afraid to go against the crowd behavior and they frequently do so. Warren Buffet famously said, “Be fearful when others are greedy, and be greedy when others are fearful.” (Crippen, 2011). If one think over it, the wisdom behind this advice can be understood with simple examples. By this advice, Buffet meant to say that one should invest in stocks when most others are selling and vice versa and we see these behaviors in their extreme usually during times of economic boom and recession. The basic law of demand and supply in economics is sufficient to understand the wisdom behind Buffet’s advice. When something is in fashion or has high demand, it is more likely to be selling at premium than fair price let alone at discount. But when something goes out of fashion, i.e. those who don’t have it avoid it and those who have it sell it, it is more likely to sell at a discount. This is why value investors avoid stocks that are in fashion because they are more likely to be sold at premium prices. Similarly, they see economic recessions as ideal times to purchase stocks due to depressed values. In other words, they execute the strategy of buy low and sell high in a perfect fashion and this explains why they enjoy impressive returns over the long term.

One of the facts in investing is that one can never be 100 percent sure because there are too many variables outside the control of the organization and similarly, the future is always uncertain. Thus, value investors make sure they purchase a stock at significant discount to the security’s intrinsic value, something they call “margin of safety” (Fidelity). In other words, even if their calculations are off by a certain proportion or their expectations regarding the future do not fully materialize, they still have higher probability of making a profit because they had already accumulated the security at significant discount. For example, a value investor determines the stock is being sold at a price of $10 but its actual intrinsic value according to investors’ calculation is $15. In other words, by purchasing the stock at $10, the value investor has significant margin of safety. Even if the stock price doesn’t eventually rise to $15 and instead $13 turns out to be the right value, the value investor will still walk off with a return of 30 percent despite being off-the-mark. But if the stock price is $14 and the value investor estimates the intrinsic value to be $15, he may avoid the stock despite still getting it at a discount because of low margin of safety that doesn’t leave much room for error.

It is clear value investing is the best investing strategy because it is common sense and focuses on the long term instead of trying to time the market which is very difficult if not impossible to do. But value investing requires patience and high emotional intelligence which explains why not everyone is suited to it. But those who do have the patience to wait and the willingness to do proper homework, the rewards are worth it.

References

Crippen, A. (2011, August 11). Warren Buffett Explains Why Fear Overshadows Greed. Retrieved April 12, 2014, from http://www.cnbc.com/id/44108052

Fidelity. (n.d.). Growth vs. value investing. Retrieved April 12, 2014, from https://www.fidelity.com/learning-center/investment-products/mutual-funds/growth-vs-value-investing

Rothery, N. (2014, February 27). Value investors might be better off on vacation. Retrieved April 12, 2014, from http://www.theglobeandmail.com/globe-investor/investment-ideas/strategy-lab/value-investors-might-be-better-off-on-vacation/article17137417/

Tier, M. (2013). The Winning Investment Habits of Warren Buffett & George Soros. St. Martin’s Griffin.