What is the Difference Between a Gamble and an Investment?
“If shoeshine boys are giving stock tips, then it’s time to get out of the market.”
~ Joe Kennedy Sr.
The teenagers in our lives are asking us about Bitcoin. And Robinhood. And GameStop. The adults in our lives are asking us about Bitcoin. And Tesla. And the business their best friend is starting that needs investors. We’ve been to this picnic multiple times in our professional lifetimes. Each time, capital was swirling because of low interest rates, easy cash flow and high markets. Alan Greenspan called it “Irrational Exuberance” in 1996. In the early 2000’s every investment with a .com at the end of it could be the next big thing. And who lived through 2007 with any money at all and not remember how fun that was when the party was over?
A year ago, some thought it possible that the economy could come crashing down as no one understood what the consequences of a global pandemic would be on the global economy. And yet here we are with easy money, low interest rates, multiple government stimuli, low taxes and demographics that are demanding consumption. The champagne is flowing in the investment world, even as so many are falling through the cracks. And this creates the perfect storm for speculation- as people want to get their money fix fast to feel like a winner. So, should you be on the sidelines with your tried-and-true strategy, or should you join the party?
We’re not going to tell anyone what to do in a blog, but we will walk you through how we think about any process for determining if you should invest in something.
If you don’t know what you are investing in, then why would you ever do it? Do you have a basic understanding of it? Do you know that a bank is using your deposit to loan money to someone else, charging them interest, keeping some and giving some to you? Simple- yes. Do you understand that when you buy a bond you are loaning money to an entity that promises to pay you back with interest at a certain time? Do you know if you invest in a company (a stock) you are essentially buying into a business, and your return is based on how well the company makes a profit and grows in value? Do you realize you can lose money in all of these (including cash, if you consider inflation)? If you don’t understand the basics of wherever you put your money, you are taking on risk you should probably reconsider.
Next- how does that investment make money? There was this guy who was producing PHENOMENAL returns for his clients for decades. Everyone was thrilled. He was hard to gain access to because he could only take so many clients at a time. But his success made so may people want to use him that they just kept coming. Until the gig was up. A family member turned him in for fraud and Mr. Madoff went to jail. His “return” was cash from new investors being transferred to old investors- it was the true definition of a pyramid scheme. We still feel bad for Kevin Bacon. But there was no underlying asset producing any sort of anything- it was literally all smoke and mirrors.
Mentioning regulation after mentioning Bernie Madoff may not be the best timing since he was such a regulation FAIL, but theoretically, we think it’s a good idea to keep your investments as transparent as possible. While you’ve probably laughed at reading huge prospectuses, just the fact that they have to be produced is a good thing. While companies can bury lots of key information, they do have to tell the truth or face the justice system. The simpler the disclosures, the easier it is to understand. When working with new investors, we encourage them to read bits and pieces at a time and start with small amounts of money. This way, if they do have a loss, they can treat it like an educational tool to be smarter next time. Even Warren Buffett claims to have made some whopper bad investments- but he often also adds how much he learned from them. Almost all of our thought processes have come from decades of experience of our own as well as studying those who came before us and shared their experience.
Next, is the investment you are considering liquid? How liquid? This is a big deal, because not only can the environment change, so can your personal life. If you are trying to do a risk/reward analysis of putting new money into something and can’t afford to not be able to get it out- that is a sign that maybe you shouldn’t do it in the first place. Maybe you have the tools to offset that illiquidity risk- an ample supply of cash and good income streams may do the trick. Then you can consider a little illiquidity in your portfolio.
If you have passed through all of these processes and are still interested in the investment, don’t put more in than you can afford to lose. Many actively managed funds have policies that they will not allow any one company be more than 5% of the fund. This is to ensure that the business risk of a company can’t destroy the rest of the fund on its own. Be careful how much of your capital you put in any one investment and make sure you can afford to lose that capital- not only now, but also the future value of it if you would have put it in something more traditional. One client answered his own question with, “If I invest and lose, I’m going to be sorry I lost that money. But if I hit the full upside, that’s not going to change my life one bit. So why bother with the risk?” Brilliant.
Every asset you own should have a purpose specific to you. What is a car worth? To someone in the country, a lot more than to someone in a city with public transportation and expensive parking! If you can’t identify the purpose, and don’t have a concrete idea of how that asset will achieve the purpose, then why do it? Now, your answer may be, “For FUN”! Great- then budget for the fun money. Some people like vacations- some like slots. You be you.
One last thought. Some have asked, “Isn’t it all a crap shoot? Should I just keep cash in the mattress?” Well, first, good luck convincing the insurance company it was there when the house burns down. Second, what the heck is a Dollar? It’s a piece of paper that the world has agreed on, for now, as a way to trade goods and services efficiently. Could that blow up? Sure. Everything is intertwined, though. If that goes, so goes normal. Every. Single. Asset. Has. Risk. Understand what you are doing and choose your combination wisely.