Personal Finance (Sec. 6)

FUNDAMENTALS OF FINANCE

A Guide for Helping Professionals

Adam J. McKee


SECTION 6: Investing


Throughout this book, I’ve been very critical of various ways of saving money.  I’ve repeatedly stated that your money must be working to make you more money.  If you stick it in a cookie jar, it is just sitting there losing value because of inflation.  In this section, we will look at various options for investing your money.  Investing is the process of putting your money to work making you more money.  There are many different ways to invest money.  Some are good, some are just okay, and others are downright bad.

There is a lot of age-old wisdom out there as to what is the best way to invest.  Most of this sage advice (that’s usually wrong) revolves around two major concerns.   The first is capital appreciation–that’s just a fancy way of saying you want to see your money grow.  The second (and most emotional) is the idea of capital preservation:  We want to make sure we don’t lose money.  What makes all this seem hard to a lot of people is that risk tends to be rewarded in the investment world.  This is true in a lot of cases; some investments are about the same as putting your money down on the horse races.  Some are nearly completely safe (U.S. Government Bonds), but there will be very little capital appreciation.

What we want to do to be successful investors (defined as someone who can make money grow quickly and safely) is sift through the many options available and find opportunities that others have missed or simply can’t take advantage of.  They are out there.  They depend a lot on what is going on in the world.  The overall economy, the political climate, the vacillation of particular economic sectors and industries, and tons of other things must be considered.  What this means is that you can become wealthy by investing, but you must become a good investor.

This translates into two basic facts that you aren’t going to like:  You have to be very disciplined, and you have to do a lot of homework.  By disciplined, I mean a couple of things.  You have to have the grit to stick to your investment rules, and only modify the rules when you learn something new about how money works.  You have to take emotion out of the equation completely and make investment decisions on a completely rational basis.  If you make investment decisions based on being excited or scared, you will make terrible mistakes and wipe yourself out.

When I talk about doing homework, I mean a couple of different things.  As Jim Cramer’s fans can tell you, he advocates spending at least 1 hour per week sifting through the news and reports on each of your investments.  The idea is to have a small handful of diversified investments that you understand completely.  More generally, you should read everything you can get your hands on concerning the different investment opportunities you may pursue.  Different times call for different measures.  You have to know how to “play” the different types of investments to keep your year over year returns in the double digits.

This means that not only do you have to follow Cramer’s advice and do your homework on individual companies, but you also need to study “macroeconomic” factors such as how manipulation of interest rates by the federal reserve impact the bottom lines of different sectors and the individual companies within those sectors.  You need to be able to predict the impact of market forces on the value of individual stocks.

I want you to become a “lifelong learner” when it comes to finance.  As you become more knowledgeable, you’ll be able to read and understand important investment books by brilliant minds like Peter Lynch, Warren Buffett, and Benjamin Graham. I suggest opening a trading account as soon as possible.

Try to find a “deal” where you get trades for free when you sign up.  This will let you play around with a small amount of money so you can get used to the interface and learn how to make trades before you start investing any real money.  Most of the big trading sites have an “education” tab, and most people never click on it.  That’s a terrible shame!  Study that educational material, and understand the concepts well enough to determine if you can use the information.

Investing Versus Gambling

Financial market participants tend to use a lot of gambling lingo that may be unnerving to the average person thinking about getting into the markets.  Traders make big bets, small bets, and hedge their bets.  The difference between investing and gambling may not be readily apparent, and many hard working folks don’t like the idea of gambling with large sums of hard earned money.   In my opinion, the critical difference is knowledge and risk management perspective.

If you stop to think how gambling works, the logic isn’t all that difficult to grasp.  Most gamblers are taking a risk with an unknown probability of success in the hopes of massive gains.   You may be able to buy a lottery ticket for only 1 dollar, but the probability of winning is so remote that it is a bad bet.  If the “fun factor” of risking that dollar is worth the cost to you, then go right ahead and play.   The same goes for every bet in the casino.  Each and every game in the casino has a statistical probability of working out in the house’s favor.  If you stay and play long enough, you will lose all of your money.  Such is the nature of gambling.

Most people that claim to be “investors” are really gamblers that can’t admit that they have a problem.  The difference, then, lies in the mathematics of probability.  I seriously doubt than any casino employee thinks of herself as a gambler.  More than likely, she can tell you the degree to which the probabilities are in her favor.  Gambler’s call this quantity their edge.  To my way of thinking, value investors have the bullish bias of the markets as their edge.  If a company is as good as the median participant in the economy, then the shares of its common stock should go up in price over time.

If we couple that with the magic of compounding, we can see why investors like Warren Buffet have been successful over long periods of time.  This also explains why day traders and hedge fund managers even actively managed mutual funds can’t seem to beat the S&P 500 on average.  They aren’t taking advantage of the constant edge that organic economic growth provides because they tend to trade frequently and quickly.  Market timing is usually a coin toss bet; in a game such as that, the gambler has no edge.

In the world of financial markets, there can be many different kinds of edge.  This is why so many different people can win and lose at so many different financial activities.  Without attempting a probability analysis of every possible market, I’d like to suggest a framework for thinking about your own investment ege.  We can begin by considering two different classifications:  There are qualitative edges, and there are quantitative edges.  When I say qualitative edge, I mean an edge that you describe in terms of words.  Many investors invest in Apple because the company makes “awesome products.”  Many people invest in Tesla because the company is “changing the world.” I’m not about to say that these assessments are not true or that they can’t be used for investing.  I wish I had the vision to be an early Tesla investor.  I wish I had seen the awesomeness of the iPhone when Apple was a struggling little computer company that couldn’t compete with the PC for market share.

My issue with qualitative strategies is that they are inherently subject to our visceral reactions to companies, products, market conditions, and host of other factors that may or may not be objectively reasonable.  Qualitative strategies are by nature more subjective than they are objective.   Blame it on my indoctrination into the empirical world of social research, but I prefer strategies based on objective measurements.  I prefer quantifiable probabilities.  The ability to express your trade strategy in terms of objective probabilities is a wonderful gift.  It can tell you what trades are investments, and what trade are gambling.  Without that knowledge, you can go investing at the craps tables, and you can invest in stock that you quickly realize you don’t want to own.

To come full circle, investors are different from gamblers in that gamblers hope that they will win; investors know that they will win.  I don’t mean that they will be up every single day, but that over the long run their capital will appreciate.  If you can’t articulate your edge, then you are gambling.  I suppose that there is an argument to be made that according to this definition, nobody is an investor because you can never be 100% certain.  There comes a point in life where your only option is to assess the probabilities and ignore the repercussions of the extremely improbable.

I could have an aneurysm and die in my sleep.  I have to assume that this will not happen and be prepared to go to the office tomorrow.  A meteor could strike the earth and end all life as we know it.  I don’t pretend that this is impossible, but maintain that it is highly improbable and don’t let it affect my investment decisions.  You can’t plan for the total collapse of the economy of the United States (in terms of your portfolio anyway).  You can plan for market corrections, for the lowering of bond ratings, and fluctuations in interest rates.  History teaches us that these sorts of things do happen, and they happen on a cyclical basis.  There will be a market correction at some point in the future.

If you can say what will happen to your portfolio if the S&P 500 drops 20% overnight and the answer is not “lose 20%,” then you are likely an investor.  If you say that you aren’t worried about it because you have a twenty-year investment horizon on your value based portfolio and you know that historically losses from a correction are made back in less than 18 months, you may be an investor.  If you say that your portfolio is delta neutral and you will profit from the spike in volatility, you are most likely an investor.  If you have no idea what will happen, then you are a gambler.  The point is to identify—and if possible quantify—your edge.


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