Investment Philosophies

Over the last 4 years in my Financial Markets journey, I’ve had the fortune to observe different ways in which people have made really good returns.

The interesting thing about all these people is in the psychology and the way they’ve chosen to invest — and here’s the punchline, there is no one single “do this and you’ll get results” way of making money in the markets.

What was however common amongst all these people was the temparement with which they chose to invest money. All of them had a unique overarching belief in the way markets worked and they stuck to that belief regardless of what was “hot” in the markets today. So much so that they stuck to it for decades at a go.

I’ll make an attempt to showcase two of the worlds I’ve been a part of. While they may appear different prima facie, people in both worlds are just taking different approaches in extracting the same returns from Market Inefficiencies.

The World of Quants

When I first got a taste of financial markets, it was through the lens of being a Quant on a trading floor. For those of you who do not know what a Quant does, a one liner to it is that we make complex mathematical models to find the “true” price of a financial asset (might be a stock, a derivative, or a currency) and use that to take bets on the market — either betting that the price of the asset would go up or it would go down depending on the current market price and the price that I get from my model.

\[\begin{align*} &C = N(d_1)S_t - N(d_2)Ke^{-rt} \\\\ &\text{where } d_1 = \frac{\ln \frac{S_t}{K} + (r + \frac{\sigma^2}{2})t}{\sigma \sqrt{t}} \\\\ &\text{and } d_2 = d_1 - \sigma \sqrt{t} \end{align*}\]

An example of a mathematical model is the Black Scholes Model which gives us the price of a derivative called an Option

The interesting thing about the world of quants is that they very rarely tend to focus on the underlying business of a financial asset. They rather just focus on the historical prices of the asset and believe that there is an ability to predict (forecast) the future from the historical prices.

In the world of quants, you stringently develop a strong robust mathematical model based on historical prices and put all your faith in the model to predict the future.

The World of Fundamentals

The world of what are called fundamental investors (or value investors ) have been popularized by Warren Buffet and Charlie Munger through their extremely strong record at Berkshire Hathaway.

Fundamentals based investing can be broken down into three simple tenets:

1. Remembering that stocks are businesses
   Every stock is ultimately a piece of the underlying business itself and gets its value from how good or bad the underlying business is. A “good” business should be valued higher than a “bad” business. There is hence an intrinsic value to every stock which may or may not be equal to its market price.

2. Think in terms of Mr. Market
   Value investors think of the broader stock market in terms of a drunk overenthusiastic man (“Mr. Market”) who at times is sane and is ready to buy or sell the stock at a reasonable price similar to what its intrinsic value is. At times Mr. Market has had too much to drink and he will quote you prices which are way out of whack from the intrinsic value.
   Do not worry when Mr. Market does that — he will get sober over time and bring the prices back to normal. But while he’s at it, you might be able to get a good bet to make either going long the stock or short the stock.

3. Always build in a Margin of Safety
   There are always risks in understanding the true value of a business — unlike hard sciences, social sciences are a messy world. There are so many things that could go wrong: you trust the management of a business to do right but they turn out crooks, customer preferences for a product might just change (who uses Blackberry Phones anymore!).
   Since the world we live in is messy, when trying to value a business, always bake in a margin of safety — hence there is no one true intrinsic value per se, but a range of values which are reasonable. Buy or sell a stock only when it goes outside that range.

In the world of fundamental investors, stocks are businesses with a range of reasonable intrinsic values and you buy or sell when the market is too irrational about a stock.