Value investing versus the efficient market hypothesis in terms of profitability and risk management for retail investors
Sviatoslav Iasenytskyi
Following decades of massive financial bubbles, from dotcoms and housing in the 2000s to tech stocks and digital assets in the late 2010s, it is reasonable for investors to seek strategies and principles that will help them manage risk and receive satisfactory returns while not losing their wealth when the bubble bursts. In this essay, I will discuss (a) the Efficient Market Hypothesis and (b) value investing, as well as the argument over whether markets are efficient and whether it is feasible to profit from market inefficiencies. After that, I will contrast the two strategies' advantages and disadvantages for retail investors. I will conclude in favour of value investing since it views investing as a skill and follows the margin of safety risk management principle. The results of prominent value investors and funds, and behavioural finance findings will cast doubt on the efficient market hypothesis . However, the hypothesis’ usefulness in terms of diversification will also be appreciated. Retail or individual investors buy or sell securities on financial markets without a professional qualification and have smaller portfolios than institutions. 1 This group accounts for a significant part of investments in markets. For instance, in 2020, American households owned 58% of the US equity. 2 Profitability measures how much an investor earns from their assets by receiving dividends or selling an asset for more than it was purchased for. Risk management is closely related to profitability, as it recognizes possible threats to capital and deals with uncertainty. 3 It allows investors to adjust their positions according to their risk tolerance and desired profitability. Value investing is an investment strategy that focuses on choosing stocks with prices below their intrinsic value. 4 Intrinsic value is a measure of the basic worth of an asset, independent of its market price. 5 This investing approach was first fundamentally presented by Benjamin Graham in his well-known book 'The Intelligent Investor'. Value investing analyses a variety of characteristics, such as a company's long-term prospects, management, financial position, history of dividend payments, and current dividend rate, to determine its proper market capitalization. 6 Intrinsic value is estimated by examining the firm's financial performance, cash flow, profit margins, business model and numerous metrics like price-to-book or free cash flow. An important role plays the concept of the ‘margin of safety’. It means that an investor should
1 Hayes, A. Retail Investor . https://www.investopedia.com/terms/r/retailinvestor.asp. 2 U.S. Securities and Exchange Commission. What We Do. https://www.sec.gov/about/what-we-do. 3 Kenton, W. Risk Management in Finance. https://www.investopedia.com/terms/r/riskmanagement.asp. 4 Boyle, M. Value Investing . https://www.investopedia.com/terms/v/valueinvesting.asp. 5 Boyle, M. How to Calculate Intrinsic Value. https://www.investopedia.com/terms/i/intrinsicvalue.asp. 6 Graham 1965: 325.
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