Locklin on science

Investments for dummies

Posted in investments by Scott Locklin on November 20, 2010

Since I have a weblog, a trading skunkworks and occasionally work for people in the quantitative finance domain, I’m occasionally asked by friends and acquaintances about investments. “Should I buy gold?” “What do you think of investing in company X?” or my favorite, “where should I put my money?”

The fact of the matter is, I don’t know the answer to these questions, and compared to most people, I probably am an expert on such things. I’d say, in reality, very few people in the world really knows the answers to these questions, and if they know, they’re not going to be telling you. To really understand why, consider what you’re investing in when you buy a stock.

When you buy a unit of stock, you’re buying a legal contract entitling you to part of the profits of a corporation. What is a corporation? It’s a legal arrangement for providing goods and services to the public, and providing some vaguely defined way of sharing the profits with the owners. The owners being, the people who own stock in the company. The owners are protected from legal risk incurred by the actual agents of the corporation. In other words, if a Lockheed executive tries to bribe a congressman and actually gets into trouble for it, the shareholders won’t go to jail. This is socially useful in that the shareholders can’t be expected to be accountable for the tens of thousands of Lockheed employees. While shareholders are protected from legal indemnity, they’re not protected against the financial shenanigans of the agents of the corporation. This is something that people rarely think about: if the corporation they’re invested in is manned by criminals, they probably won’t realize any returns. Even assuming the agents of the corporation are honest, that doesn’t mean they’re not dumb, or at least optimizing a utility which isn’t aligned with that of the owners. For example: many companies will incur massive debts; debts which could eventually bankrupt the company. Accounting systems are also a bone of contention. While most American companies are reasonably honest, the way that the accounting is done is hugely relevant to how a company is valued.

There are a couple of ways ordinary humans think about stocks. They may think the idea behind the company which issued the stock is a good, see a stock going up in price, and so they buy into the trend. They may actually know something about the the company: perhaps they notice lots of other people lining up to pay $4 for a cup of sugary caffeine water at the local coffee house, and so, see it as a good investment. That’s all well and good, but if you don’t know about the company’s plans, the intimate details of it’s accounting methods, and who is running the joint, you really don’t know anything about it. If you’re buying on the trend, well, that can work too, but unless you’re willing to sit around and white knuckle the trend to its ultimate conclusion and time it well enough to sell at the top, you are just gambling. Not that there is anything wrong with that.

My investment advice: invest in the small businessman. I have a minor celebrity pal who did time in Los Angeles. As all Angelinos are required by local statute to have perfect teeth, Veneers are an extremely profitable business. My pal ended up learning all about the various pieces of machinery which can be used to make this sort of thing easier on a dentist, as he had it done to his own choppers, and he ended up investing in individual dentists. He would do stuff like invest in the machinery, invest in young dentists purchases of business partnerships (Dentists usually buy into a practice, in order to have access to equipment and a ready flow of customers) and share in the profits. Since dentistry is a virtually risk free proposition, my pal made a good deal of money off of such investments.

I can see people shifting uneasily in their seats already. How did my pal know these Dentists would pay up? Well, my pal pretty much had to investigate only the individual dentists he invested in. If you’re investing even in one equity, you’re investing in a whole lot of people -people you will never know, who may or may not be honest people who are working in your interest. My pal also had a lot more legal leverage over his investments, as he owned substantial fractions of their enterprise; far more than you’d own in a given equity. In that sense, his risk is a lot lower than someone blindly investing in stock of a company.

Most people never seem to think of this option: investing in small businesses. It does require some social skills and imagination, but it seems to me, for the average joe who doesn’t even understand the rigors of double entry book keeping, let alone the difference between an accrual and an operating cash flow, this is a better bet. Otherwise, you’re just gambling. Investing in the latest trend in the stock market seems the height of folly for the regular schmoe who can’t be bothered to understand even how a very small business works. I guess if you can’t be bothered to invest in a small business, something like public utilities makes a lot more sense than speculating in something you don’t understand.

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24 Responses

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  1. Sameer Parekh said, on November 21, 2010 at 3:15 pm

    That would be a good idea, except that it is ILLEGAL. (For most investors.)

    • Scott Locklin said, on November 21, 2010 at 8:52 pm

      Investing in a small business is illegal? In what country?

      • Allen Smith said, on November 22, 2010 at 5:29 pm

        I think he may be referring to the SEC requirement to be an accredited investor. I think this only kicks in when an incorporated company actually sells stock under SEC regulation D.

        There is nothing to stop two people from entering into a private agreement ( I hope! ) that is not a sale of stock in a company

  2. Harshal Patel said, on November 22, 2010 at 6:54 am

    Sounds like a good plan but how to do ordinary Joes find business to invest in?
    There is online market place that I know of…..a Kiva for small business investment vs. loans

    • Scott Locklin said, on November 22, 2010 at 7:06 am

      I’d figure you’d invest in stuff you actually know about, like my pal with the nice choppers. Perhaps something in the local neighborhood. A Kiva type thing isn’t a bad idea either, if you could figure out how to structure the investments.

  3. ramblingperfectionist said, on November 22, 2010 at 12:36 pm

    But the crucial flaw here is that if you’re investing in a small business you don’t have the assurance that somebody else has investigated the company, which you do for pretty much all large businesses. Sure, they might have missed a lot of stuff, but if it’s big enough at least your chances are better. I guess it makes sense in some cases, but you’d need a hell of a lot of social skills, and lots of entrepreneurial friends. (The two are probably connected.)

    • Scott Locklin said, on November 22, 2010 at 5:58 pm

      Worked out great with AOL, Enron and Waste Management, right? Sure, there is a certain amount of safety in “everyone else does it.”
      Looking at the local Thai restaurant and noticing how much better they’d do with an extension or some better chairs or something, or loaning their cousin Berle some money to hire some extra dudes to do a particularly big contracting job seems to me a better investment for the average schmuck than buying equities. Stocks were only sold to the average jerk … I don’t know, for the last 40 years or so. Has the average jerk done well with his stock investments? I sincerely doubt it; mostly it’s made them easy meat for brokers and pro traders. People seem to have withdrawn their money from the markets, and rightly so -why not invest the money where it does some good?

  4. ssnyder said, on November 22, 2010 at 3:59 pm

    Do you have to be an accredited investor to invest in situations like this? Or is there a better way to structure these types of investments in small businesses?

    • Scott Locklin said, on November 22, 2010 at 6:01 pm

      All you need is a contract. I’m not talking about investing in a 200 person company. I’m talking about pitching in with your cousin Juan Valdez on his taco truck. If you can’t do a business deal like this, you should probably leave equities alone.

  5. [...] The stock market vs. the investing in small businesses.  (Locklin on science) [...]

  6. Jeff Joseph said, on November 22, 2010 at 9:57 pm

    Well, that was refreshing.

    I preach the same sermon on my blog so I intend to be an avid reader of your’s, going forward.

    Please feel free to visit: http://www.venturepopulist.com

    Prior posts on point with your topic include:

    Underachievers Please Try Harder
    Playing the Angel
    Hybrid Theory

    (yes, those are all album titles)

    Great Post !!!

    Best,

    Jeff

    • Scott Locklin said, on November 22, 2010 at 10:06 pm

      Neat website you have there; some good ideas.

      This is just common sense to me. I mean, at this point, I know how hard it is to intelligently pick a stock on any time scale. Why wouldn’t an investor invest in something they understand instead?

      • Gabe said, on November 23, 2010 at 3:20 am

        Auditors get paid by the same entity that they audit, so how reliable are they really… you make the judgment call. On top of uncertainty in numbers maneuvering, how can we average Joes keep track of all the everyday management decisions that ultimately will affect the big E (Earnings)? It seems like there are a lot more gambling and uncertainty in the stock market than your average next door neighbor or uncle Vinny’s auto repair/ video rental business. The most rewarding thing you can have with investing in small business is to see your thesis play out right in front of your very eyes in the time frame you set, after you do your research and decide to take the risk. There’s nothing more skillful investing than that.

        -GL

  7. erehweb said, on November 23, 2010 at 5:17 am

    Interesting advice. But what would you say for investing in a 401k or the like, where that’s not an option? A broad-based index fund? Or would you try to pick a sector if possible?

    • Scott Locklin said, on November 23, 2010 at 5:28 am

      In your case, I’d say use a simple trend following system on whatever sector ETFs you have access to.

  8. tosh icavenger said, on November 23, 2010 at 5:22 am

    Small businesses could really thrive with this type of investment,when banks wont loan any money.contracts would be the risk.

    • Scott Locklin said, on November 23, 2010 at 5:29 am

      Essentially, we’re changing from a high trust society to a low trust society. Places like Italy have always been like this. They’re also pretty nice places to live when you don’t have to deal with their bureaucracy.

      • William O. B'Livion said, on November 25, 2010 at 4:36 am

        Spent a vacation in Italy once apon a time.

        Might try it again some day if I’m ever in that hemisphere again, just to see if it’s really the shithole that it seemed to be.

        It might be a good place to be really rich or really f’ing lazy, but it really seemed like a shitty place to be in the middle (working poor, middle and upper middle class). It was dirty, crowded, the fruits and vegetables in the stores were expensive (everything was expensive) and not as nice as most places in Chicago.

        Maybe outside the big cities are nice places to live, but then if I didn’t have to work I’d live up in Tahoe.

  9. Deniz said, on November 26, 2010 at 12:32 am

    I have two brothers who are in the retail business. Running a business is tough, running a partnership is even tougher. I know of many partnerships that have ended in disaster. But, it’s hard to argue on the basis of anecdotes. I know of only two studies and the limited data suggests that there is no premium to investing in entreprenuerial activity through proprietorships, S corps, C corps, etc. You get the same return as you would in investing in public companies, with a higher concentration of risk (but also with higher potential non-monetary benefits). Of course, there are good small-business investors, just as there are good stock-pickers.

  10. Maynard Handley said, on November 26, 2010 at 5:03 am

    It seems to me, reading these comments, that people have very strange ideas about investing.

    “Investing” conflates two very different ideas:

    (a) Return on capital, which is exactly what it says — people are willing to give you a bonus, in the form of interest, if they can use your money for some purpose. Return on capital is basically the return on treasuries.

    (b) Business savvy, which is the nebulous collection of skills required to see a business opportunity and work towards solving it. This may take the simple form of forming a partnership with another person, or the higher level form of being a VC; but the point is that it is a SKILL and an OCCUPATION — it involves research, investigation, thought.

    Where we have a social disconnect is that people want to engage in (a) — passively allowing people to use their capital for some purpose, but they wish/hope/believe that they are entitled to the sorts of returns generated by successful practitioners of (b).

    Given that much of wall street is devoted to separating the common folk from their money, Wall Street has zero interest in clarifying for people the difference between (a) and (b). (See, for example, the ongoing saga of social security privatization.)
    But there is indeed a difference. And it’s a foolish person indeed who assumes that they can generate the return of a pro based on gut instinct and rumors, simply because they’re engaged in some magic activity called “investing”.

    There’s nothing wrong with not being interested in investing. I’ve very little interest in it, and society needs people who spend their time learning physics, practicing medicine, building cars, etc. But then, I’m not the one trying to pretend that the entire US population should become “investors” with their life savings, and that this operation will miraculously result in them all earning 8% annual returns for the rest of their lives.

  11. GK said, on November 26, 2010 at 12:53 pm

    I agree 100% with Scott. Regarding SEC regulation D, I’m not entirely sure when the securities laws kick in. I don’t practice securities law but I did research this one time. I think when the company passes a set number of investors or a set amount of revenue, the securities laws kick in. Before that, it is not regulated. Most mom and pop businesses are not governed by securities laws.

    I’d also add investing in real estate to Scott’s example. We just had a 3-5 year bubble that burst. But in a non-bubble real estatemarket (almost all of the 20th & 21st centuries) good real estate investors did well.

  12. Morning Take-Out - NYTimes.com said, on December 8, 2010 at 3:29 am

    [...] writes Scott Locklin. In reality, very few people in the world know the answer to the question, “Where should I put my money?” And if they do, Mr. Locklin says, they are probably not going to tell you. Nevertheless, the [...]

  13. [...] idea, so work on that, and get coffees with hedge-fund managers.)  Scott Locklin recommends you invest in small businesses rather than the stock market, but that sounds like [...]


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