Byrne's Eye View

Everyone who writes about finance knows that selling short is risky because there's no limit to how much you can lose. But this is because people who write about finance rarely think like value investors. Consider: the stock is at $10, you think it's worth $5, so you sell it short with 4% of your portfolio, expecting to make 50%. Over the next month, the stock rises by $5, to $15. Now it's (a little bit more than) 6% of your portfolio. Bad news? Possibly, but now the expected profit is 67% ($10/$15, instead of $5/$10), and perhaps the odds of realizing that profit are higher as the stock gets more egregiously overpriced.

I think that, contrary to convention, short-selling is what I think of as a pure value trade -- a trade which, once you make it, fluctuations in market price cause the same change in portfolio allocation that you'd make anyway.

Unfortunately, the only other pure value trade I can think of is the currency-standardization trade. If you expect that A is a better currency than B, and thus that people will standardize on A, every time A rises relative to B it becomes a better standard than B. This is probably why gold bugs sound the way they did in 1962 (read Barrons from that time -- a good business school library should have it -- and you'll find the same kind of arguments you hear today).

As the gold thing should illustrate, there are many more pure trades outside of the value school. For example, venture capitalist and global macro expect Peter Thiel seems to be talking about the same thing in this essay. What he ignores is that most all-or-nothing bets have a time limit, and that people who bet on the current bubble being right are, in general, poor to the extent that they make this bet. Or put another way: Wilbur Ross could invest a month's worth of the dividends, management fees, and interest he's getting on his steel, coal, and textile holdings, and he'd have a bigger bankroll for betting on the Singularity than the average venture capitalist. But if Thiel has picked the right bubble, he's making a great pure trade on it.

Momentum investing consists of mostly pure trades: if it doubles, buy it, if it doubles again, allocate twice as much of your portfolio to it (done!). Macro investors make those trades, too -- a thesis like "Money is flowing into Singapore" is more or less identical to "Buy financial assets in Singapore while they appreciate, and sell if they drop."

What's odd is that investors shy away from these simple trades. The daily turnover makes it clear that investors are more concerned with what Coca-Cola will make next quarter than with what they can make over a century and a half. I suspect that investors hate these trades because they require so much conviction: when you leave everything after your decision up to the market, you're showing a lot of faith in that decision.

The average investor will accept a lower return, if it includes ample opportunities for second-guessing.