Optionality: What You Are Unsure Of Might Just Make You Win

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We were returning from Goa. It was a long drive back – and at 11 pm we were hungry. The choices, just after we passed Nelamangala were:

  • go through the city or
  • go on NICE road which ditches the city traffic but is much more in terms of distance.

It was a Saturday night. So we would take more than hour to reach home in either direction. Which way to take?

If we went on NICE road – our usual choice – we would not get any food. We wouldn’t find a place for a toilet break (which you have to plan for, with young kids). But we would definitely reach in an hour and 20 minutes, and we wouldn’t find much traffic – that much we could be sure of.

The other route – through the city – was full of traffic. You can’t see it above but it was all red in Google maps, which is how Bangalore is nearly all the time. We were being told that the journey would take 1 hour 40 minutes or more. And bad traffic, after a 10 hour drive, would be a lousy thing to encounter. But the plus point was: we could get a bio break, we could stop for food, and there was one other thing: the traffic situation could improve.

At 11 pm on Saturday, it would take us 30-40 minutes to hit the city, and in that time, we could have seen the traffic situation change in our favour.

Meaning: we might actually get home in the same time as the NICE road option, and have the ability to grab food along the way.

What should we choose?

And that brings us to today’s topic: Optionality.

Optionality: The Value of the Uncertain

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You have to make choices all the time. You tend to choose a known thing because the unknown, or the uncertain is scary. You choose to take a job at a big company because the future of the little startup is unknown. The big company means a certain salary for sure, and a constrained growth path. The startup could grow disproportionately, or shut down.

The optionality – which we usually dismiss as “risk” – is quite valuable. People quote the success of a whatsapp, but that’s not even necessary. Some of the people that joined funded startups, in recent times, got the benefit of both – a decent salary (which means you don’t compromise on lifestyle) and stock options. Even if the startups died – or semi-died like Snapdeal, most employees now have that valuable experience in their resumes and will land better jobs.

The optionality was the opposite – the startups both paid well and gave them a better career than the big startup. The startup was actually a better choice for most – even if the startup died.

What did we do? We could have chosen the NICE road and we’d get home within a certain time. But we chose to drive through the city. The optionality of the city gave us access to the chance that traffic would ease.

It did. We managed to stop for a food/bio break, and still get back home in the same time. The risk worked for us, because the risk is what we took.

The Meaning of this, In Relevance

That is a lot of gyan, Deepak Shenoy. What do you really want to say? And why does it connect with investing?

There are choices you make in investing that give you optionality. Let’s take an example.

The Fixed Deposit Versus The Liquid Fund

A question we recently had on the Capitalmind Premium Slack channel was:

I have some money to park but likely for less than 3 years. Is it still better to use a Liquid fund based on taxation?

The choice was to either park the money in a fixed deposit, or to put it into a liquid mutual fund. (See this video where we’ve demonstrated that such an option over the longer term can save you 80% on tax versus a fixed deposit)

The idea is: Fixed Deposits give you interest, and that interest is added to your taxable income. Liquid funds, when you withdraw, charge you tax on only on the gains that you make on what you withdraw. So if you draw less than you put in, you pay a lot lesser tax. And if you cross the magic 3 year barrier, income tax reduces substantially on any further withdrawals.

So here the choices are:

  • A fixed deposit where interest rates are known (7%) and you pay tax on income whether you use it or not. Even at a lower tax rate of 20% (for a middle-income person) this is an effective return of 5.6%.
  • A liquid fund where rates might be lower (6.6%) and market linked, but you don’t pay tax till you actually sell. Yeah, marginally more risk too.

Here’s where optionality kicks in.

The Fixed Deposit has no optionality. You know your effectively yield is 5.6%. That’s it. Regardless of when you actually need the money.

The Liquid fund has lots of optionality. If you need the money after four years, the tax system will give you an effective yield that’s 6.3% and you don’t have to pay tax till you get out. If you needed only half your money then you pay lower tax on that amount, while the rest grows untaxed until you do need it.

And the best part: if you get out within three years, you make about 5.3% but that’s not as bad.

There’s other factors of course – returns could vary based on the market (which could be in your favour too, another piece of optionality), and liquid funds have marginally more risk than fixed deposits.

The choice is, actually, quite simple: get into liquid funds. Because even if you did withdraw it all before three years, you’re not much worse off.

This is Why Buffet Is Wrong and Buffett is Right

Warren Buffett once said this, and said it well: (See video)

If you hand me a gun with a thousand chambers, a million chambers in it, and there’s a bullet in one chamber and you said “Put it up your temple, how much do you want to be paid to pull it once?” I’m not going to pull it. You can name any sum you want. Because it doesn’t do anything for me on the upside, and I think the downside’s fairly clear.

The optionality is negative. This is also a good reason to make a choice. Most ULIPs are like this, and you really shouldn’t buy any of them.

Buffett however is wrong when he says you should think you have only 20 investments to make in your life, so you’ll think hard about each one. You gotta think hard, but it’s silly to only think you have 20 to think about. You might make mediocre returns on the first 15, and then you’ll get all tense because come on, there’s just five more.

But the optionality here is in your favour. You don’t have to stop at 20. You can learn and find the next twenty. You can invest in 50 stocks and make fantastic returns, as many mutual funds have demonstrated. You don’t have to restrict yourself to something because Buffett told you to; his lesson was more about buying stuff with more research, so that you don’t get saddled with investments you have no idea why you own.

Sometimes, in the long run, optionality is not understandable. If you are in a job that is too easy, then it’s quite likely that job will be automated away. Your options today are: learn a new skill while your job is easy, or just live the easy life. Too many people don’t realize they have the first option.

Every option that sounds like it’s “safe” is probably not. And every risk isn’t worth running away from. Sometimes, taking a risk is the only non-risky option, but you’ll learn about it much later. Understanding and embracing optionality is about making a bet.

And as things go, you lose 100% of the shots you don’t take.

5 COMMENTS

  1. Separate your Alpha and Beta exposure because options confuses. Know what you are paying for both Strategic and Tactical allocation.
    Never forget : Return = Cash + Beta + Alpha – Cost & Taxes

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