Risk and Reward of Value Investing

Food for thought. Consider the example here:

Let say someone hands you a six-shooter and he had slipped one cartridge into it. You just need to spin it and pull it once to your head. If you survive, he will give you $1 million. You reject, perhaps that $1 million is not enough. Then he offers you $5 million to pull the trigger twice – now that would be a positive correlation between risk and reward! (Example pulled from one of Warren Buffett’s articles)

I think most people have the idea that risk and reward are correlated in a positive fashion. The higher the risk, the greater the return. Sound common sense and logical.

However, the exact opposite is true with value investing. The lower the risk, the greater the return. How? Consider this:

If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case.

The greater the potential for reward in the value portfolio, the less risk there is. This is what Ben Graham meant by having a margin of safety. You don’t buy businesses worth $1 million with $0.9 million. You leave yourself an enormous margin. Just like when you build a bridge, you insist it can carry 30 tonnes, but you only drive 5 tonnes trucks across it. The same principle works in investing.