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Paradox of value investing
- Thread starter Cutten
- Start date
Cutten
Nice to see someone taking an argument to its illogical conclusion. You can apply pretty much the same argument to the normal concept of risk return for trading.
Back to value investing:
Which situation is more likely.
Scenario 1
All market particpants work out that a stock is worth X. Joe investor with his superior intellect and analytical capabilities determines that a stock is worth 2x. Once Joe has taken his value position the other market particpants slowly come around to Joes way of thinking and the stock price moves to 2x over time.
Scenario 2
Joe does his analysis and buys some stock. Over time things change for the economy, market, industry, and the company. The stock price moves up. Things changed in his favour so maybe Joe just got lucky.
IMO value investing is hold and hope. The lucky ones pick the right stocks and get to be lauded as investment gurus.
Nice to see someone taking an argument to its illogical conclusion. You can apply pretty much the same argument to the normal concept of risk return for trading.
Back to value investing:
Which situation is more likely.
Scenario 1
All market particpants work out that a stock is worth X. Joe investor with his superior intellect and analytical capabilities determines that a stock is worth 2x. Once Joe has taken his value position the other market particpants slowly come around to Joes way of thinking and the stock price moves to 2x over time.
Scenario 2
Joe does his analysis and buys some stock. Over time things change for the economy, market, industry, and the company. The stock price moves up. Things changed in his favour so maybe Joe just got lucky.
IMO value investing is hold and hope. The lucky ones pick the right stocks and get to be lauded as investment gurus.
Quote from womblevader:
Cutten
Nice to see someone taking an argument to its illogical conclusion. You can apply pretty much the same argument to the normal concept of risk return for trading.
Back to value investing:
Which situation is more likely.
Scenario 1
All market particpants work out that a stock is worth X. Joe investor with his superior intellect and analytical capabilities determines that a stock is worth 2x. Once Joe has taken his value position the other market particpants slowly come around to Joes way of thinking and the stock price moves to 2x over time.
Scenario 2
Joe does his analysis and buys some stock. Over time things change for the economy, market, industry, and the company. The stock price moves up. Things changed in his favour so maybe Joe just got lucky.
IMO value investing is hold and hope. The lucky ones pick the right stocks and get to be lauded as investment gurus.
righttttt...never a scenerio 3 eh?
Quote from FerdinandAlx:
I'm not catching your drift. Suppose I buy a stock for $40 that I determine is worth $80.
If the stock goes to $50 this doesn't affect my margin of safety as I'm sitting on a 25% profit. You seem to forget that the equity you build up in a position acts as a margin of safety just as well.
Now suppose that I identify another stock that's again trading at 50% of it's intrinsic value. The rational thing then, would be to roll over my current position into that stock.
Opportunities like that don't always come along though. What's the point in selling the first stock for $40.01 just to keep my capital in cash for the remaining time? That doesn't make any sense so you lock in your cost base at a price you determine is right. You then wait for the stock to reach it's intrinsic value or you wait until a better opportunity comes by.
What Cutten is saying is that why do you wait until the stock is $40 before buying? Surely you might consider buying it at $75, $70 $65, or $60? Taken to the extreme, why not buy at say $79.50. You have $0.50 profit there! Another difficulty of value investing is : by insisting on a big enough safety margin, you might just miss buying it at all. The stock might go down to 40.50 and proceed to go up to $80.
Thanks tyrant for "getting it".
The real nub of the paradox is this - how can it be rational to own at $41 on the way up, if it was not rational to own at $41 on the way down?
Cost basis of $40 is irrelevant (except for tax reasons - let's assume a zero tax entity such as a pension fund, to make things simpler). Cost basis has no impact at all on what the correct decision at $41 is. Otherwise, it would be rational to own if you already owned from $40, but irrational to own if you were flat. An investment cannot be both a buy and a sell at the same price for two people identical in every respect except their cost basis or lack therefore. If you bought at $40 and it's now $41, you have $1 profit per share. You are in an identical position as someone who is flat and just bought at $41, but had $1 per share profit from some other investment. You can't say the first person should be long and the second shouldn't be long. Cost basis has no impact on investment decisions at the *current* price.
The real nub of the paradox is this - how can it be rational to own at $41 on the way up, if it was not rational to own at $41 on the way down?
Cost basis of $40 is irrelevant (except for tax reasons - let's assume a zero tax entity such as a pension fund, to make things simpler). Cost basis has no impact at all on what the correct decision at $41 is. Otherwise, it would be rational to own if you already owned from $40, but irrational to own if you were flat. An investment cannot be both a buy and a sell at the same price for two people identical in every respect except their cost basis or lack therefore. If you bought at $40 and it's now $41, you have $1 profit per share. You are in an identical position as someone who is flat and just bought at $41, but had $1 per share profit from some other investment. You can't say the first person should be long and the second shouldn't be long. Cost basis has no impact on investment decisions at the *current* price.
Quote from Cutten:
Cost basis of $40 is irrelevant (except for tax reasons - let's assume a zero tax entity such as a pension fund, to make things simpler). Cost basis has no impact at all on what the correct decision at $41 is. Otherwise, it would be rational to own if you already owned from $40, but irrational to own if you were flat. An investment cannot be both a buy and a sell at the same price for two people identical in every respect except their cost basis or lack therefore. If you bought at $40 and it's now $41, you have $1 profit per share. You are in an identical position as someone who is flat and just bought at $41, but had $1 per share profit from some other investment. You can't say the first person should be long and the second shouldn't be long. Cost basis has no impact on investment decisions at the *current* price.
But this would be a very irrational way of "investing" performance-wise. Value investors are just traders on a longer time frame.
Maybe a good analogy is the buying decision process you would go through when buying a brick and mortar private business, say a fast food restaurant.
Say a good friend of yours if retiring and offers you his sandwich shop. Say it makes 45k per year net after all wages and costs, depreciation of appliances and inventory and all taxes. Say you personally would consider 8 years net profit as your personal 'fair value' goal of a business. 8x45k = 360k. Now say you look for a safety cushion and are only willing to pay 80% of what you would usually consider 'fair value' in order to protect against unseen risk. That's 288k.
Your friend offers you the restaurant for 285k. Do you 'have' to buy it if you're a value investor? And then, what if you buy it for 285k and somebody offers you 365k (i.e. more than fair value) two years later? Do you 'have' to sell it now because you're a value investor?
I think most value investors look at value investing in public companies as owning parts of an actual business, not as a mechanical regime that forces them to buy and sell a piece of paper religiously at certain price points.
Say a good friend of yours if retiring and offers you his sandwich shop. Say it makes 45k per year net after all wages and costs, depreciation of appliances and inventory and all taxes. Say you personally would consider 8 years net profit as your personal 'fair value' goal of a business. 8x45k = 360k. Now say you look for a safety cushion and are only willing to pay 80% of what you would usually consider 'fair value' in order to protect against unseen risk. That's 288k.
Your friend offers you the restaurant for 285k. Do you 'have' to buy it if you're a value investor? And then, what if you buy it for 285k and somebody offers you 365k (i.e. more than fair value) two years later? Do you 'have' to sell it now because you're a value investor?
I think most value investors look at value investing in public companies as owning parts of an actual business, not as a mechanical regime that forces them to buy and sell a piece of paper religiously at certain price points.
Quote from Cutten:
Thanks tyrant for "getting it".
The real nub of the paradox is this - how can it be rational to own at $41 on the way up, if it was not rational to own at $41 on the way down?
Cost basis of $40 is irrelevant (except for tax reasons - let's assume a zero tax entity such as a pension fund, to make things simpler). Cost basis has no impact at all on what the correct decision at $41 is. Otherwise, it would be rational to own if you already owned from $40, but irrational to own if you were flat. An investment cannot be both aa buy and a sell at the same price for two people identical in every respect except their cost basis or lack therefore. If you bought at $40 and it's now $41, you have $1 profit per share. You are in an identical position as someone who is flat and just bought at $41, but had $1 per share profit from some other investment. You can't say the first person should be long and the second shouldn't be long. Cost basis has no impact on investment decisions at the *current* price.
You seem to forget that the equity you build up in a position acts as a margin of safety just as well.
You also seem to forget that the decision to sell is based on the company reaching its intrinsic value. It doesn't come up at any other price level except if a better investment opportunity presents itself.
Scenario 1 is more likely becausae once joe realizes that the stock is being traded at less then what itts worth, and if the stock has good prospects and past growth etc. then he will buy many shares of that stock because the stock is being undervalued.
Cutten
Nice to see someone taking an argument to its illogical conclusion. You can apply pretty much the same argument to the normal concept of risk return for trading.
Back to value investing:
Which situation is more likely.
Scenario 1
All market particpants work out that a stock is worth X. Joe investor with his superior intellect and analytical capabilities determines that a stock is worth 2x. Once Joe has taken his value position the other market particpants slowly come around to Joes way of thinking and the stock price moves to 2x over time.
Scenario 2
Joe does his analysis and buys some stock. Over time things change for the economy, market, industry, and the company. The stock price moves up. Things changed in his favour so maybe Joe just got lucky.
IMO value investing is hold and hope. The lucky ones pick the right stocks and get to be lauded as investment gurus. [/QUOTE]
Cutten
Nice to see someone taking an argument to its illogical conclusion. You can apply pretty much the same argument to the normal concept of risk return for trading.
Back to value investing:
Which situation is more likely.
Scenario 1
All market particpants work out that a stock is worth X. Joe investor with his superior intellect and analytical capabilities determines that a stock is worth 2x. Once Joe has taken his value position the other market particpants slowly come around to Joes way of thinking and the stock price moves to 2x over time.
Scenario 2
Joe does his analysis and buys some stock. Over time things change for the economy, market, industry, and the company. The stock price moves up. Things changed in his favour so maybe Joe just got lucky.
IMO value investing is hold and hope. The lucky ones pick the right stocks and get to be lauded as investment gurus. [/QUOTE]