This is the first of a ten part series similar to what I did with “The Biggest Myths in Economics”. Many of these will be familiar to regular readers, but I hope to consolidate them when I am done to make for easier reading. I hope you enjoy and please don’t forget to use the forum for feedback, questions, angry ranting or adding myths that you think are important.
Myth #1 – The “Investing” Myth
Investing myth numero uno is, ironically, about the very word we use to describe what we do when we’re “investing”. Interestingly, most of us are not actually “investing” when we buy stocks and bonds. We are actually just reallocating our savings. This sounds mundane and perhaps even unimportant, but I think it has important ramifications for how we construct our portfolios.
In economics the word “investment” is defined as follows:
Investment – Spending, not consumed, for future production.
In finance the word “investment” is often defined as spending with the expectation of future profit. We tend to use the latter definition to describe the purchase of stocks and bonds, however, I think it’s more appropriate to use the prior definition as it is more consistent with the economic concept of “saving” than “investment”. Let me elaborate.
If you earn some income that goes unspent you are simply saving. If you use some of your income to buy a sandwich you’re spending on current consumption. But if you’re the entrepreneur who owns the sandwich shop and you buy a machine that makes sandwiches then you’re spending on something that enhances your future production – you are actually investing, or spending for future production. If the sandwich shop goes on to do great things then the sandwich company might raise capital so they can invest in more sandwhich making machines. They might even issue stocks or bonds to do this. These instruments are issued to finance the sandwich company’s investment spending. And when these shares trade on a secondary market like a stock exchange, they are financing nothing. They are simply being exchanged at values that the buyers and sellers perceive the sandwich company to be worth.
The kicker here is that the issuance and exchange of these shares can finance future investment, but is not actual investment. It is, more properly, a simple reallocation of savings (unspent income) which finances investment spending. When you buy shares of Apple you are not spending for future production. You are reallocating your savings from cash to stock. If you happen to finance investment spending at say, an IPO, then you’ve reallocated your savings so a firm can then spend for future production.
Now, some people might say: “Who cares Cullen? You’re such a stickler for details!” Well, this is true. But I think it’s an important distinction as “investing” conjures a sort of sexy get rich quick profit chasing endeavor whereas the allocation of savings is rather boring and conjures up a much more conservative sort of endeavor. The concept of allocating our savings is much more consistent with what most of us are doing when we seek growth and protection of our hard earned savings by allocating them to the financial markets. While this is a fairly minor change in thinking it’s one that I think many “investors” could benefit from as it will get them out of the mentality that they are involved in some sort of “beat the market” race to get rich and instead allocating their hard earned savings in a manner that is more likely to serve their real long-term financial goals.