Dominant Strategies in Investing
Efficient market theory, which is widely popular among academics and institutional investors alike, suggests that financial markets are efficiently priced and that over long periods of time, no investor can realistically expect to outperform the market. The evidence in support of this view is staggering and actively managed portfolios have indeed underperformed comparable index funds through the years.
There have also been some notable exceptions however. Warren Buffet for instance, has amassed a fortune of nearly $50bn through his ability to successfully capitalize on market inefficiencies. Is he an outlier? Of course, there’s only one Warren Buffet. That being said though, Buffet is not alone and his success, together with other market beating investors, demonstrates that markets are not always efficient and that there do exist market-beating strategies.
Value investing, which was originally conceived by Benjamin Graham and made popular by Buffet, is perhaps the best example of such a strategy. As the name suggests, value investing involves buying securities at a discount to intrinsic value and then selling when the price of the underlying security reverts to fair value. The spread between the market price and the estimated intrinsic value is known as the margin of safety. In some sense, thinking about this strategy in context to the bidding strategies we discussed in class, margin of safety can almost be thought of as the difference between bi and vi. By selecting investments with the largest difference between bi and v, (when bi < v,), an investor ensures that they receive the maximum risk-adjusted return. The Buffet’s of the world succeed using this strategy because they invest in businesses that they understand and can come close to accurately assessing v,.
While the majority of portfolio managers aren’t able to successfully utilize this strategy for a whole host of reasons (i.e. short-term capital base, poor valuation skills, herd-like mentality, trading expenses), those that have have been able to exploit the inefficiencies in the market and realize consistent long-term returns.
– mjg274
http://www.my10000dollars.com/
http://www.economist.com/node/