The Proper Strategy

11 02 2010

In “The Intelligent Investor,” Benjamin Graham defined investing as an operation “…which, upon thorough analysis, promises safety of principal and an adequate return.” So which investment strategy best fulfills these requirements? From empirical evidence only, one would have to admit that value investing has been the most successful investment strategy in terms of returns. But is there a catch? The efficient market hypothesis says that to produce above market returns requires an above market level of risk. Most people would interpret the term risk as the “safety of principle” that Graham uses in his definition of investing. In fact, many academics define risk as share price volatility. I think it’s pretty clear that share price volatility and safety of principle have no correlation. As Warren Buffett notes in his speech “The Superinvestors of Graham-and-Doddsville,” the academic definition of risk says that buying $400 million dollars worth of assets for $80 million is less risky than buying them for $40 million-just because of the increased volatility that arose from the decrease in price. The academic definition of risk is silly.

Now that we’ve done away with the fallacious definition of risk, we can consider what causes a loss of principle, (ie. real risk). The answer is simple: knowledge (or lack thereof). If I know that the business I purchase is going to produce X amount of cash, there would be no risk in buying it at the proper price (more on that later!). Unfortunately, it’s nearly impossible to know the exact cash flows of a business. Investing will always carry an inherent risk of principle loss. But if knowledge is the key to reducing risk, the least risky investment technique would require the investor to study his investments and understand them forward and backward. This is precisely what is required when valuing a business. Thus, value investing is the least risky active investment strategy.

Since value investing provides the investor with the highest returns at the lowest level of risk (relative to other strategies), The Reason Investor portfolio will be invested strictly based on value.

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