Investments for dummies
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.