The Asymmetrical Nature of Risk and Return
Senior Vice-President & Chief Investment Officer
At Empire Life Investments Inc our investment philosophy is grounded in the belief that the best way to achieve long-term capital appreciation at low risk is to follow a rigorous process-oriented value investment approach.
The merits of value investing to preserve and grow wealth over the long term are well documented. In fact, Warren Buffet, the second richest man in the world, is a value investor. He along with Ben Graham, the founder of value investing, reasoned that if stocks were purchased at a low enough price, there would be a margin of safety built into the investment that would protect against any unexpected price declines. This is the foundation of our investment strategy.
Protecting the downside is really what differentiates value investors from other types of investors. It is the firm belief that the risk-return tradeoff should never be far from our sightlines because the tradeoff is asymmetrical. Let me illustrate by using a simple example: If an investor invests $100 in the market (assuming no dividends are paid) and the market declines by 30%, the investor is left with $70. If the market then appreciates by 30%, the investor now has $91. The investor still has less than when he started.
Assume another investor begins with $100 (assuming no dividends are paid) and the portfolio appreciates by 30%, this investor now has $130. If the portfolio then declines by 30%, the investor is left with $91.
In both cases the investor needs the portfolio to appreciate 43% to recover the absolute dollars lost.
Now, this is a very rudimentary illustration but the message is clear: The way to preserve and grow wealth is to always keep in mind the tradeoff between risk and return. This is what differentiates a value investor. Not only are we interested in uncovering stocks that have plenty of upside potential and pay handsome dividends, we are always mindful of the risks inherent in stocks. The margin of safety helps us protect our portfolios from the wealth-destroying elements of risk.
For more on our investment style check out Gaelen’s talk at Ivey Business School’s Ben Graham Centre for Value Investing..