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Optionality and opportunity

The weak markets today provide an option to investors to improve their returns later

Optionality and opportunity

'Optionality' is one of the concepts frequently written about by Nassim Nicholas Taleb, the great philosopher cum derivatives trader. This is surely a combination of professions unique in human history. This combination makes Taleb uniquely qualified to write about the philosophy behind investing. If one wants to understand markets and investing deeply, reading his books could be one of the best things you could do.

Taleb derives the word 'optionality' from options in the financial sense, but the concept is much wider. In investing, an option is defined as an instrument that gives the investor the right, but but not the obligation, to buy an underlying security at a predetermined price. Of course, the dominant use of options in India is in speculative punting. However, properly speaking, they're something that can be used to limit the downside risk while keeping the upside potential open.

What Taleb points at while talking about this concept of optionality is that this is true for all investing, as well as a lot more in life. In a way, all of investment research is about limiting your downside risk while enhancing the chances of making gains. In fact, this is the key difference between the speculator and the real investor.

However, there's a deeper theme to this. When we invest in equity, there are so many variables which we have to consider - the company, the business, the management, the technology, the industry, the economy, the market and so much else. Deciding that an investment is worthwhile involves having an opinion and taking a call on so many diverse factors. We could be wrong on any one of them. If we are wrong, then the investment may work out badly and it's value may decline. No matter how wonderfully skilled we are at our research, we could be wrong on anything. In fact, we could be wrong on many things and all of us often are.

That's where 'optionality' comes in. As investors, we have to somehow make choices that limit the inevitable downside risk of equity investing, while leaving our upside unfettered. Two of the best ways of doing this are diversification and value investing. I'm sure that didn't come as a surprise to you but what is actually surprising is how many investors tend to forget about this.

Which is where we come to today's situation in the equity market. There are way too many investors who, at an intellectual level, understand and appreciate this, but at a psychological level are unable to take advantage of it. The weak markets that we are seeing are nothing but an opportunity. They present to us investors not risk but optionality. If we choose good stocks, then we are assured that we are buying them at a relatively good value. That puts a cushion under us in case we fall.

The occasional market fall that comes to equities is actually not a bad time to be somehow tolerated while we wait for the good time. This is the good time. This is actually the time when you will make your gains while later you will simply encash them.