Investing 101 : Pursuit of Convexity

It’s been a while since we published the first note in our “Investing 101” series”. A quick rehash of the previous note leaves us at a point, where it becomes rather imperative, to understand the interplay & impact of the two vectors of “Redundancy” & “Optionality”. We had also laboured on the idea of investing being an “infinite game” and how the goal of the player(investor) is to get stronger with time and be in the game forever. This is exemplified by the strong desire of almost every wealthy individual to leave a legacy that will not only transcend their lifetime but also profoundly impact the lives of their progeny and perhaps even the societies they associate with.

The picture above is akin to any other chart that highlights the beauty of compounding. The fundamental assumption of compounding, however, is your ability to stay invested in order to enjoy its benefits. The chart above represents the path that determines your ability to do just that … which is to stay invested. However, let’s not confuse this with staying invested in any particular security or asset. We are only interested in staying the course of continuous wealth creation over time. The returns may come from just about anywhere(discussed later as “Optionality”).

“Redundancy” as discussed in the previous note, enables us to deal with stressors. However, redundancy doesn’t get built overnight. Efforts to build redundancy with speed pushes us away from “Risk taking”, which is vital to wealth creation. Your investment program should ideally ensure you have only so much redundancy(Safe haven assets) that will help you ride out the uncertainties that cannot be priced in(Black Swans). This kitty will change over the investing lifespan. Interestingly, while it will continue to grow in absolute terms, it’s growth in relative terms will need to slow down, thereby leaving more room for risk taking, aka, “optionality”.

“Optionality” is to be understood at two levels. In its simplest form it means having a lot of options. Enhancement of “Redundancy”, in effect, enhances our ability to explore and take on risks in more than one asset and on a larger scale (of value as well as time). At this stage, it would make sense to clarify that the focus needs to be on creation of wealth in absolute terms, instead of being fixated with CAGR. For, the CAGR(Compounding)is a function of your ability to stay the course guided by the two vectors we discussed above.

“Optionality” when applied to investment decision-making, should lead to asymmetry. Hence, just being right is not enough. We need to ensure that we loose less when we are wrong but gain substantially more when we are right.

Therefore, with enough “redundancy” at our disposal, we are able to harness “optionality” a lot more. The culmination of the two result in the convex path of wealth creation, which not only gets you to a higher orbit of wealth, but also helps you stay there.

Mon, 22 Feb 21