Types of Investments

Fundamentals of Market Investing by Adam J. McKee

It seems that we’re trapped in a Catch 22 scenario.  We don’t want to lose principal, so we don’t want to take on any risk.  Nevertheless, if we don’t take on any risk, we can never beat inflation, and we end up losing money instead of making it.  The real answer to the puzzle is risk management and the dependability of long-term trends.  There are entire books about how economies grow and contract, but we’ll grossly oversimplify and say that as long as the United States government remains solvent and our population continues to increase, the economy will continue to grow over the long haul.

The economic strength of a nation is a function of the number of workers times the productivity of those workers.  Productivity is a function of education, training, technology, and other advantages that make it possible for workers to do what they do faster and better.  For nearly a century, America’s abundant natural resources, industrial might, capitalist inducements, and superior education have given us a productivity edge that no other nation could match.  We’ve lost much of that edge as our educational attainment has fallen to appalling lows.  As other countries catch up to us in productivity, we must increase our numbers to stay competitive and retain our position as the world’s most exceptional economy.

The fastest way to recruit highly motivated workers and keep our brain trust from further draining is to promote immigration.  To suggest that we need to limit immigration to protect “American jobs” is pure folly and shows a disturbing lack of knowledge of how economics works.  Economies are social systems, and their size is a function of the number of participants.  Rapid economic growth requires high productivity and high participation.  When the competition has populations in the billions, we are at a disadvantage that productivity increases cannot overcome.

To treat jobs as a finite resource is, to paraphrase Jeremy Bentham, “ignorance upon stilts.”  With each new participant, there comes a new demand for goods and services.  Immigrants will need a place to live, food to eat, and a way to get to work.  Isolationism is the bitter enemy of long-term prosperity.  Economic stasis is always a temporary anomaly; over any length of time throughout history, you will note that economies are either expanding or contracting.

To think regionally is wrong-headed in the worst kind of way from the perspective of economic prosperity.  I say regionally because America has no shortage of jobs; we have a mismatch between geography and education and those empty slots.  This may seem like a political aside (well, maybe a little), but what is good for the overall economy is good for your portfolio.  I would be overjoyed to find out that we had 100 Million new workers starting tomorrow.  With most of those folks investing in their own 401(k) plans, all of my assets are sure to rise in price.  Those immigrants would want to educate their children, my classes would be full, and my job would be more secure.  The law of supply and demand will not be denied.

If you ask a random set of people walking down the street “what was the biggest financial downturn in U.S. History?” they would most likely respond “the Great Depression.”  It was a time of terrible hardship and misery, but we got over it.  The economy got over it.  The excesses of the Roaring Twenties gave way to the Great Depression, and the depression gave way to post-war prosperity.

When you measure it in decades, you will not lose betting on the growth of the United States economy (and the world).  When we invest in the broad economy, there are two significant ways to participate.  We can buy parts of companies that we think will do well and make lots of money in the years to come, or we can loan people money so that they can build, invest, and grow.  We can start a company, which has very high risks of failure but substantial rewards if we succeed.  We can invest in a company as a partner or a silent partner, which spreads the risk around but to doesn’t do away with it to any substantial degree.

The Sleep Test of Risk Tolerance

Investors often speak of risk tolerance.  The idea is that each person has an amount of risk that they find acceptable and can be comfortable with over the long haul.  There are many measures of risk, but perhaps the most relevant is whether you can fully understand the risks that you are taking, and you still sleep well at night.  To really pass the sleep test, you need to consider the worst-case scenario.  If you cannot handle that worst case, then you need to be investing differently.

Over the long haul, the most profitable way (available to the average American trying to save for retirement) to invest in the growth of a company is to buy stocks.  Think of a stock as a certificate of ownership that gives you the rights to a tiny fraction of the company.  If you own land, you usually have a deed.  A company that has stocks (not all do) has millions of little “deeds.”  In the past, shares were handsome certificates suitable for framing.  These days, actual paper stocks are an oddity, printed in small numbers as promotional items and to be given as gifts.

The vast majority of stocks are electronic, and the buyer only sees them as a set of numbers in a brokerage account.  As companies get bigger and make more money, each of those “shares” becomes more valuable.  You can make money if you buy them low and sell them when the price goes up.  The problem with buying stocks is that the price can go down, then you are in the terrible, awful position of buying high and being forced to sell low of the company is, in fact, a loser.

“The Market”

The idea of a “market” can be very confusing in the investment world because the term can be used in several ways.  In the most general sense, “The Market” refers to the sum of all securities that can be bought and sold as investments.  Stock investors may use the term more narrowly to describe just the stock market.  The term can also be used to describe a particular, actual market, such as the New York Stock Exchange.  Most often, we will use it in the very general sense of all buyers and sellers of investments.

If you don’t want to take on that risk, you can instead loan the companies and governments money that they have to pay back no matter how the business is doing.  You make these loans by buying bonds.  Bonds are a little like stocks in that there are potentially millions of them for sale.  The most significant risk of buying bonds is that the company you loaned the money to can go bankrupt.  The bankruptcy court may order them to pay bondholders back as much as possible, but this may be a few cents on the dollar or absolutely nothing.  Because the markets reward risk, the safest bonds pay the least interest.

What we want to do to be successful investors (defined as someone who can make money grow safely) is sift through the many options available and find opportunities that provide attractive returns at an acceptable level of risk.  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 reasonable 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 or when your circumstances change substantially.  You have to take emotion out of the equation entirely 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.  Active investors will tell you that different times call for various measures.  According to this “school” of investing, you have to know how to “play” the different types of investments to keep your year over year returns in the double digits.

Passive investors will tell you that sticking to the plan is the most important thing.  As we will repeatedly see, becoming a good investor can be confusing because there are so many different perspectives as to what is the best way to invest.  We will explore the thinking of the different schools, and, by the end, you will have no doubt on which side I come down.  Note that my thoughts are nothing special; I ask you to consider the quality of my sources rather than have any faith in me as we move along.

Regardless of which school of investing you subscribe to, you absolutely must understand the investments that you make before you buy them.  This means that not only do you have to follow Jim Cramer’s advice and do your “homework” on individual investments, 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, mutual funds, ETFs, and any other investment that you are even thinking of buying.

I want you to become a “lifelong learner” when it comes to an understanding of investing.  As you become more knowledgeable, you’ll be able to read and understand important investment books by brilliant minds like Peter Lynch, Warren Buffett, Burton Malkiel, and Benjamin Graham.  I suggest opening a trading account as soon as possible so that you can start making “paper trades.”

Try to find a “deal” where you get trades 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 is a terrible shame!  Study that educational material, and understand the concepts well enough to determine if you can use the information.

One warning about using the educational material on brokerage websites:  Brokers make the most money when you move in and out of investments because the fees they charge you for buying and selling stuff are their most significant source of income.  They often suggest “active” strategies that end up eating away your money and making the broker rich instead of you.  If the information is tied to a brokerage firm, consider if it really benefits you or whether it just benefits the brokerage.  As you may have gathered from Hollywood films, stockbrokers are fairly wealthy compared to the rest of us.  If they are getting wealthy because of trading fees, then you are losing money making them wealthy.  This violates Rule Number One:  Never lose money.

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.  Note that stock market gamblers don’t call themselves gamblers; they are referred to as speculators, and their bets are called speculative investments.  There are plenty of wealthy investors in the world, but the wealthy speculator is a rare breed.

If you stop to think how gambling works, the logic is not very difficult to grasp.  Most gamblers are taking a risk with an unknown but incredibly low probability of success in the hopes of massive gains.  You may be able to buy a lottery ticket for only one dollar, but the likelihood 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.  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 cannot admit that they have a problem.  The difference, then, lies in the mathematics of probability.  I seriously doubt that any casino employee thinks of herself as a gambler.  More than likely, she can tell you the degree to which the chances 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.  This also explains why day traders, hedge fund managers, and even actively managed mutual funds cannot 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.  (This controversial statement makes many people angry, especially stockbrokers and active fund managers.  I shall do my best to justify it in a later section).

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 in so many various economic activities.  Without attempting a probability analysis of every possible market, I’d like to suggest a framework for thinking about your own investment edge.  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 advantage that you describe words instead of numbers.  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 valid 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 policies based on objective measurements.  I prefer quantifiable probabilities.  The ability to express your trade strategy in terms of actual probabilities is a wonderful gift.  It can tell you what trades are investments, and what trades are gambling.  Without that knowledge, you can go investing at the craps tables, and you can invest in a 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 cannot 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 the 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 I don’t let it affect my investment decisions.  You can’t plan for the total collapse of the economy of the United States (regarding your portfolio anyway).  You can prepare 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 occur 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 are not 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.

Investor Jargon

As with any industry of society, Wall Street has its own particular words and phrases that make this world seem alien to the outsider.  You’ll get much more out of reading and watching videos about investing if you learn some of the necessary jargon.

Wall Street:      In the physical world, Wall Street is a map location in New York where the world’s most famous stock exchange is located.  The name is commonly used to stand for the entirety of the financial sector, such as when investors say “There is no free lunch on Wall Street.”  In the internet age, money and securities can change hands regardless of where the traders are physically located.

Market: Investors use the term “Markets” to refer to the overall business of trading securities, and as a proxy for the average profit or loss that investors have had over a period of time.  To “beat the market” means that an investor has performed better than a particular benchmark during a specific period, usually one year.

Long:  If you buy a security such as a stock, you are long that security.  The term can also be used to describe the characteristics of a security or portfolio, such as “I’m long volatility.”  If you own options that give you the right to buy a security, you are also long that security.  You have a stake in the price.

Short: The idea of being “short” can be confusing to new investors because we usually think of securities as something that you buy or sell, and when you sell, you no longer have a stake in the security.  In the markets, you can sell something that you don’t own and be “in the hole,” if your broker will loan you the security that you are “selling short.”

Upside / Downside:  When an investor sees a lot of “upside” in an investment, she believes that there is still a lot of profit to be made.  Conversely, when an investor stands to take a loss trading security, there is said to be a lot of “downside” risk.

Color:  Used as a request for additional information, such as “can you provide us with some more color on that?”

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Last Modified: 6/26/2018

This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.

Open Education Resource--Quality Master Source License



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