Needing A Framework

At Moller Financial, we recommend a rules-based approach to investing using mostly low-cost, broad market index funds. The preponderance of evidence on investing is clear that this strategy offers the greatest chance of success in the long term. Mutual funds have been a boon to individual investors by easily facilitating the ownership of hundreds of companies; index funds have provided this access at vanishingly low cost.  One of the few downsides to this approach, in my experience, is that by focusing on indexes and using relatively abstract investment vehicles like ETFs and mutual funds (compared to a piece of tangible property), investing money in the stock market can feel like little more than online poker, albeit less entertaining. By reminding ourselves what investing really is and what it isn’t, we can reduce the “Monopoly money” effect and build a more prudent mental framework for our investing decisions. 

One way to understand investing is to contrast it with its close relative, speculation.

• Speculation involves expending capital in the hope that the asset can be sold for a gain in the future
• Investing involves expending capital in pursuit of income or profit

The words are often used interchangeably and the academic consensus on the definitions is far from final. The fundamental difference between the two, however, is that an investment is purchased with at least the expectation of income now or in the future. A speculative purchase is made without expectation of income, although it would be welcomed. And in reality, the two ideas exist on a spectrum and various financial activities often cannot be neatly placed entirely on one side or the other. Benjamin Graham said it well in “The Intelligent Investor”,

"...some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. […] Thus, many long-term investors, even those who buy and hold for decades, may be classified as speculators, excepting only the rare few who are primarily motivated by income or safety of principal and not eventually selling at a profit.”

How can an investor make a judgment on whether an asset is too speculative for their taste and circumstance? First, let’s define the opposite ends of the spectrum. I’ll posit that a pure and non-speculative investment is one that invokes the answer “yes” to the following question – “Would I still buy it even if I knew I may never be able to sell it?” On the other hand, an extreme example of speculation would be an “asset” that has no economic value to the owner absent a willing buyer. The Dutch Tulip Mania of the 1600s is a famous example (although often exaggerated in its telling).

Let’s illustrate the characteristics by looking at a more familiar example: real estate. Different types of real estate can fall in wildly dissimilar places on the investment-speculation scale, like say an apartment complex vs. a vacant plot of land.

• The apartment complex can be reasonably expected to provide the building owner with income in the form of rent payments. The owner would surely like the value of the building to increase in the future to sell for a profit as well.
• Alternatively, a vacant plot of land does not produce income in its current form and without putting additional capital into developing it, the only reason to buy it would be a bet on another buyer being willing to pay more in the future.
• So which asset is more of an “investment” than the other? Which asset would you be willing to pay more to buy?

I don’t want to suggest that cash flow is the only reason to buy an asset or that high-dividend paying companies and rental real estate are somehow superior to other options. These assets are often costlier to buy than others and there are many companies reinvesting profit into growing rather than paying high dividends to shareholders. Sometimes the potential for future gain is higher for good reason. The takeaway from the cash flow discussion is that the price of a share of stock does have a basis in reality in the long run, although investor sentiment and expectation about the future causes the price to swing from day to day.  We recommend mostly index funds because they make it easy to buy a large number of companies and ride the ups and downs of other investors’ speculations while reaping the benefits of owning profit producing entities. You, the investor, know that owning stocks is owning a part of living, dynamic companies, each determined to succeed and generate greater and greater profits.

Finally, by focusing on the root of what it means to invest, the common impulse to time the market by buying and selling based on future sentiment appears to be more akin to dicey speculation than prudent investment. In this vein, before employing a portfolio strategy, start by asking, “Is this more like investing or speculating?” and “Is that the right place for me to be?” Speculation is more like gambling than it is investing, and Warren Buffet provides an apt summation of the subject. He had an epiphany as a young man on investing while watching other people gamble, “When I visited the casino and saw all these smart well-dressed people participating in a game with the odds against them, it was then that I realized I won't have a problem getting rich!”