Are You Gambling or Investing?

Mention the stock market or investments and some families or organizations will react with loathing and disgust, likely drawing parallels between a trip to Vegas and a call to a broker. A good deal of this is due to the cultural aftermath of the Great Depression and the simultaneous drop in the financial markets as a result from the excess of the 1920s. Yet, the primary reason for this attitude is a complete lack of understanding regarding accounting, finance, economics, and basic compounding. Yet, this attitude isn’t entirely irrational. Gasoline, for example, can be extraordinarily helpful if you are trying to power a tractor that will provide food to thousands of people. But in the hands of rash, uninformed people, you could end up with horrific physical damage and even the loss of life.
Without an understanding of what exactly a stock is, outside of an indexing strategy, the market can be a very dangerous place. (For information on what stocks are and how they are created, read Investing Lesson 1 – An Introduction to Wall Street.)
How do you know if you are gambling or investing? Here are a few simple tests to give you a clue.
1. Do you have a clear reason for investing in a particular stock or security, or are you just going on your “gut”?
In every case, you should be able to write out a short, simple explanation that makes sense to the average high school student as to why you are purchasing a specific investment. It should lay bare your expectations and they should be reasonable.
Here’s an example. Say you were interested in acquiring shares of U.S. Bank for your IRA. You might write something like this, “As of the market close on Sunday, July 1, 2007, the stock traded at $32.95 per share, or a price-to-earnings ratio of 12.66 as a result of $2.60 earnings per share. Taking 1 divided by the p/e ratio of 12.66, we get .0789, or 7.89 percent. This figure is known as the earnings yield. When compared to the long-term yield on the risk-free U.S. Treasury bonds of 5.22 percent, this amounts to a 2.67 percent higher rate for the stock. This is supposed to compensate me for inflation and the risk of investing in a stock. In and of itself, this is insufficient. However, management has vowed to return 80 percent of earnings to shareholders each year and expects to maintain growth in earnings per share of 10 percent. In other words, I am buying an ‘equity bond’, to borrow a phrase from Warren Buffett, that currently yield 7.89 percent, which will grow earnings per share of no more than 10 percent for the next few years (and probably top out at 3 percent thereafter.) In the meantime, the 4.8 percent dividend yield can be used to acquire more shares and, because they are held in an IRA, will not have taxes assessed against them. Compared to the S&P 500, this appears to offer an attractive value.
I’m not particularly concerned about competition as the bank has an enormous base of branches throughout communities in the Midwest and beyond. With metrics that are typically the highest in the big banking field – return on assets, return on equity, and a stellar efficiency ratio – it appears management is clearly doing right by owners. It’s unlikely I’ll have a lollapalooza bonanza on an investment like this, but it does offer a conservative way to compound my capital in a manner that appears to be above average compared to the broader index if left alone in an account with instructions that all dividends be reinvested.
2. Are you hoping to profit from a move in share price over the short-term, or from the long-term performance of the business?
If you ultimately expect to earn your profits in the market because a stock is going to go up as investors find it more fashionable, rather than an improvement in the long-term performance of the underlying business, you are gambling. One of the stupidest reasons to buy a stock is because you believe one of the company’s products or services is going to be a huge hit. That alone could be a reason if you believed it would result in underlying profits increasing on a per-share basis.
When you bank on someone else paying a higher price (the so-called “greater fool” theory), rather than selecting a demonstrably superior business, you are putting your financial well being in jeopardy.
3. Do you utilize leverage to amplify your return?
Margin debt is dangerous because it’s so easy to access. If you approach a traditional bank, you’re going to have to complete a myriad of paperwork, prove you have the cash flow to repay the loan, post collateral in the event you are unable to meet your obligation, go through a background check, and a whole lot more. With a brokerage firm, you may have $100,000 in assets in an account and instantly be able to borrow another $100,000, effectively leveraging your funds on a 2-1 basis. The problem, of course, comes if stocks fall – which they are often prone to do. In this example, a 20 percent drop would result in $40,000 of losses for you on your $100,000 equity, bringing your net account equity balance to $60,000.
With results like that, you may be right in the long-run, but, as the Wall Street expression goes, you’ll be explaining it to someone in the poor house. You must play your hand in a way that no matter what happens in the financial markets, you and your family will still have enough chips to participate in the recovery when it comes. We’re big fans of another Buffett assertion, “Don’t risk what you have and need for what you don’t have and don’t need.” It just doesn’t make sense to put yourself in a position where being wrong can cost you your standard of living.
If you are determined to put as much capital to work for you as possible, focus your energy on generating more cash in your professional life either by working more hours, starting a side business, cutting expenses, etc. It may take you a bit longer to get to your ultimate goal. But it will still be a much shorter journey than if you are completely or partially wiped out as a result of borrowing against your securities.