The hardest part of investing in stocks for most business people, beginner investors, and intermediate investors is stock selection. The most popular options that you may be faced with during stock selection are value stock, mutual funds, and index stock funds.
In value investing, the investor identifies undervalued stocks that are trading below their intrinsic value, then buys and holds them until the market reflects it’s fair value.
In index fund investing, investors buy an index fund or index ETF, seeking to match the performance of a major market index. If the average goes down, the fund goes down too, and vice-versa.
So, how is value investing safer then index investing? Isn’t stock picking risker?
The answer is yes, it can be; but only if you don’t know what you are doing. A true value investor knows that the stock market is an irrational place, prone to constant mispricing of businesses that they can take advantage of.
Here are five reasons why I think value investing is safer than index funds.
1. High Margin of Safety
When looking for the ideal stocks to invest in, an investor should assess the margin of safety to determine their relative risk. Volatility is widely feared in the stock market as a major investment risk, and when it hits, index fund investors can be thrown into panic.
It can quickly throw investors out of the market or lead to huge losses. However, this hardly affects value investors as they understand that price volatility does not equal risk.
A value investor purchases stocks that are trading at a significant discount to their intrinsic value. This difference between the intrinsic value and the purchase price is known as the margin of safety.
Undervalued stocks have a high margin of safety; therefore, when volatility strikes, investors don’t suffer panic, losses, and market uncertainty. Rather, they get an opportunity to purchase more shares at a lower price; hence increasing the margin of safety of their stocks.
Volatility is your friend! Let it reward you.
2. Limitless Exposure to Strategies
There are numerous strategies available in the stock market that investors can utilize and combine to create a portfolio that’s better suited for their personal goals and provide better risk-adjusted returns.
With proper research and investigation, you can find the corners of the markets that are undervalued. After researching, you can combine these stocks into a smaller, more targeted portfolio.
For example: many undervalued companies can be found paying a higher dividend than the index. By using this strategy and buying the stock, you can collect some extra yield on your investment while you wait for it to mature. Take a look at IBM for example:
By taking advantage of the price fluctuations of the market, the dividend of such companies can be a nice cherry on top.
Index funds allow investors to diversify strategies for the creation of a portfolio. However, buying an index may not give you access these companies. Most investors are limited to the use of just a few strategies. As a result, their ability to obtain risk-adjusted returns is minimal as compared to that of value investors.
3. Potential for Massive Returns
Since value stocks are purchased when they are trading below their intrinsic value, the investor has the option of selling the stock at a time when it is trading at or above its actual value.
Undervalued stocks have a potential for generating exponential profits over time if they can successfully turn around. Value investing is all about waiting out short-term market fluctuations so that you can reap long-term returns.
On the other hand, index funds don’t carry the potential to outpace the market the way value stock funds can. If you invest in an index fund, you are surrendering the possibility of massive gains.
Unlike value stock funds where any under-performing years are canceled out by the over-performing ones, index funds’ performance remains steady over time, and this means that there are no chances of exponential gains.
4. Control Over Holdings
Value investing is a safe option for investors as it allows them control over individual holdings. If you dislike a particular company due to moral or personal reasons, you simply don’t have to invest in them. There are thousands of companies to choose from!
With value investing, you can choose how many companies you want in your portfolio. You can choose the weighting, exposure, timing, etc. It’s your money to manage.
In index investing, investors have no control over any of these options, making it less flexible for those who like to control their own holdings. Index funds are controlled by the brokerage and the index overall, which can present potential risks to your portfolio.
In fact, it’s been proven many times that a small concentrated portfolio of around 10 good businesses, can outperform an index. For investors that know what they are doing, it exactly the method what Warren Buffett recommends. In fact, he even considers diversification (like and index fund) to be a hindrance to a portfolio. On the flip side however, Buffett also recommends index investing for those who don’t know what they are doing.
For a value investors who know and understand the businesses they own, index funds just don’t offer the control they need.
5. Personal Satisfaction
Investment in value stocks requires patience, as your stocks are ultimately not affected by the daily market fluctuations. As previously stated, value investing requires investors to deeply know their businesses that they own. When you know the value of a stock, then daily market prices will hardly affect you.
Value investors sleep well at night, not caring what the market does from day to day. Developing a rational plan for price fluctuations allows for value investors to reap the benefits of high returns at low risk.
Although index funds are a long-term investment, an investor has no control on what flows in and out of the index. As a result, you don’t get satisfaction of knowing why the price your stock zigs or zags. You may not even know which stock brought down the fund!
Value investing is a viable and safer option investors in the stock market as compared to index investing. The caveat here is that value investors have to know what they are doing.
If you want to outperform the index, you have to spend the time researching and knowing the businesses behind the stocks you buy. Once you have done the research and know the business, simply invest in undervalued stocks of your choice and watch them generate spectacular profits in the long-term.