Sunday, June 30, 2013

Stock Market Investors: The Jumbo Shrimp of Finance

As someone who will argue with anyone about anything, most disagreements start with different definitions of same words.  These simple misunderstandings quickly devolve into name-calling and emotional abuse as both sides are more obsessed with showing the other guy up than searching for the truth.  I am not above this as I have done my fair share of debate teabagging.  This is why I now try to define all questionable terms so disagreements can be rooted in fundamental ideas rather than semantics.

Most people are familiar with the phrase "invest in stocks," but what does that mean?  What does it mean to invest?  Is it the same thing as trading stocks or even speculate in stocks?  Investing in a general sense means giving up present payoff for a bigger payoff down the line.  There is of course a risk involved, but in an infinitely repeating experiment, investors expect to be consistently profitable.  After all, they are giving up a sure present thing for a questionable future thing.  That future thing better be a lot bigger and nicer.

But does this make sense in the stock market context?  The current meta of stock market investing is low fee index ETF or mutual funds with dollar cost averaging and a modicum of market timing for the adventurous.  Thus, it is reasonable to say that stock market investors expect a positive real return over the long term.  Studies confirm that this is indeed the case with no negative returns over any twenty year period (although there was one with flat returns from approximately 1900-1920).

But to extrapolate this into "stocks will always go up in the long term(say 20 years)" is not a sound or logical argument, although it may turn out to be correct.  The reason for the general rise in the American stock market has been due to America's continued superior productivity, churning out products and service that are in high demand.  For stocks to always go up in the long term, you are essentially speculating that corporations listed on American stock exchanges will continue to be successful forever.

Some investors will cringe at the idea that they are mercenary and amoral speculators, but defining investment as expected payoffs makes it incompatible with the stock market.  The price of issues are simply a snapshot of a deal between a willing buyer and seller.  The market has no more innate incentive to go up in real terms than to go down or sideways.  It is only through the impetus of increase in underlying companies' profits that price of shares can advance.

Thus, most investors should think of themselves as corporations with retained earnings and think about where to put that money to ultimately increase their happiness.  Sometimes that is stocks, but in case of societal collapse, some farmland in the middle of nowhere will be worth more than all the equity shares in the world.  There is a time from every asset class, from cash to gold to stocks to paintings.  Tunneling into stocks is fundamentally misunderstanding what stocks are.