Finance Without Myths: Predictive Power and the Three Logical Mistakes of Value Investors

Swapping Predictive Power for Compounding, Conviction, and Margin of Safety

Value investing, like every investing strategy, has a specific approach and makes specific claims. Many value investors make logical errors when evaluating these claims, and this article highlights some common mistakes.

These mistakes overlook what should be the main focus of every investing decision: If it has predictive power. Everything else is noise and narrative.

If you hate this article, leave a comment explaining where I missed the boat.

Disclaimer: This article is not discussing value investing as a strategy, nor is it saying that all value investors make the claims discussed. This article targets specific mistakes made by some investors. When Buffett and Munger are quoted it is for illustration purposes only, and not to attribute the errors to them.

Claim #1: The magic of compounding

Buffett famously said “Time is your friend; impulse is your enemy. Take advantage of compound interest and don’t be captivated by the siren song of the market.” Value investors point to the “Magic of compounding”, using this as a reason to buy and hold, invest long-term, and look beyond the short-term market movement.

However, any investing strategy that has alpha - that makes money consistently above market returns - will benefit from compounding. A short-term investor, a day trader, or a momentum follower will all gain from compounding, provided that their strategy has alpha. Compounding, while it may be magic, is not unique to value investing, and does not support buy and hold more than any positive alpha strategy.

But the issue is bigger. Value investing is just a series of short/medium term predictions. When value investors buy something cheap, and continue holding it, they are making a prediction about each time frame. They are assuming positive expected value before the stock returns to its highs, and they are assuming positive expected value after it returns to the high, and for the remainder of the holding period. They could have just invested for one part of that time period, and that would still be reliant on the assumptions and predictions of value investing.

Value investing is not a single long-term bet.
It is a sequence of small, positive-EV predictions, made repeatedly over time.
- The Risk Lab

The compounding claim confuses what happens when doing value investing - compounding over long periods of time - with what the strategy actually predicts - small gains and positive expected value, repeated over time. It focuses on the narrative of a stock recovering from its lows and rising, by focusing on the long-term rise from the lows, instead of focusing on the predictive power of the strategy, which is many small periods of time that have a positive EV.

Claim #2: Diversification is for Dummies

Munger said: “The idea of diversification makes sense to a point – if you don’t know what you’re doing. If you want the standard result and don’t want to end up embarrassed, then of course, you should widely diversify. But nobody is entitled to a lot of money for holding this view. It’s like knowing two plus two is four. Any idiot can diversify a portfolio.” (source: Yahoo Finance).

But sometimes, the best approach is to diversify and spread out your investments.

Certainty is something found among value investors more than other investors. Traders manage not knowing the future, dealing with it, and gaining from it. They know how to hedge and protect from tail risk, which is a way of managing uncertainty, and should be comfortable sitting with uncertainty.

Many good investments, rather than coming with certainty, come with positive expected value in the face of uncertainty. Options on a stock that might go up, puts on an overvalued company - these are examples of investments that will not come with certainty, but, provided enough knowledge, may have positive expected value. Done right, an entire portfolio can be constructed with uncertain, +EV investments.

Ignorance and certainty are related. The more a person studies the business, sees its relation to economy, the growth factors and the possible risks, the harder it is to be sure. Someone who just read a 10-k, doesn’t think about it, and reads an investment thesis could have certainty. But someone who truly looks into a company will seldom be certain.

Markets are constantly in a state of uncertainty…
and money is made by discounting the obvious and betting on the unexpected.
- George Soros

Claim #3: Margin of Safety

Margin of safety, as stated by many investors, is a core part of value investing: buy stocks trading significantly below their intrinsic value, and the gap between the current price and the fair-value protects you from downside risk.

However, if the margin of safety is real, then it is an independent source of value, and has nothing to do with the long-term holding of the stock. It is an independent prediction and investing strategy, which should have nothing to do with long-term holding.

Margin of safety conflates two sources of positive expected value: The short-term reversion, and the long-term stock growth.
They are separate, and should be kept as such.
- Refael Burton

Framing it as an opportunity to buy a long-term holding is dishonest and mixing things up. If the diversion from fair value was not deserved, than you could bet on reversion. If you think it was deserved, than buying the stock has nothing to do with the dip.

Again, like the first error, value investing, at its core, is making a whole bunch of predictions. Margin of Safety should be reframed as a prediction that the stock will revert to fair-value, and is a separate prediction from the prediction about growing and hitting new highs.

Summary

In the end, what matters is if your strategy has predictive power. If it does, conviction, diversification and margin of safety are just noise.

Investors should focus more on what a strategy predicts. If it predicts that in the long-term something will rise, it is predicting a series of short-term rises. If it assumes margin of safety, it is predicting a reversion to the mean. Anything else is distraction and narrative.

Predictive power is what matters, and the prediction, and only the prediction, is what investors should focus on.

About Finance Without Myths:

Finance Without Myths is a series about rational thinking in investing. It takes apart popular claims and headlines, and shows where the reasoning breaks. It replaces intuition and narrative with clear reasoning, explicit assumptions, and rationality.

About The Risk Lab

The Risk Lab is an investing newsletter about risk, probability, and second-order thinking. It looks at familiar market questions from new angles, with an emphasis on decision-making under uncertainty, behavioral biases and rationality.