Tadas is continuing his finance blogger wisdom series all week so don’t forget to go back and check them all out. Yesterday’s question was one of my favorites:
Question: If you could (magically) impart one piece of wisdom to all investors what would it be?
“Your best investments are likely to be made outside of the financial markets.”
People get this backwards every single day. In fact, I’ve argued that it’s the most backwards word in finance – investing. From a technical perspective, investing is spending, not consumed for future production. For instance, if you built a machine that made widgets you’d have spent for future production. You made a real investment. But if you financed that investment by selling stock (ownership in the company) then you simply financed your investment spending in a certain way. But the stock wasn’t the investment. The investment spending was on the machine.
What people really do when they finance investment spending is reallocate their savings in some way. So, for instance, if I have a bunch of excess cash sitting around earning 1% I might take that retained savings and reallocate it into broad financial markets like the stock and bond markets. These are simply big pools of assets where companies have financed their investment spending using certain instruments that are now publicly owned and through which we reallocate our savings. But make no mistake, when you buy a stock or bond on a secondary market you are not financing investment spending. You are doing nothing more than reallocating your savings.¹
Anyhow, I hope you get the gist of the story. It sounds kinda mundane and maybe even pointless. But I think it’s a paradigm shift in thinking about these things. When you stop thinking about your portfolio as a sexy high return “alpha” chasing “investment” portfolio you stop chasing returns, paying high fees and paying short-term capital gains taxes. Instead, you start thinking of your portfolio as a savings portfolio which is a safe, tax and fee efficient appropriate return generating portfolio. This perspective allows you release yourself of so many of the behvaioral pitfalls that trap many investors.
But whoa nelly did I get sidetracked – the main point is this – we don’t make our best investments in the financial markets gambling on stocks and bonds. We make our real investments in things outside the financial markets. Me personally? My best investment was relentlessly hounding a California girl during my Junior year at Georgetown. And boy did I invest a lot of time (and money) trying to convince her that I am good enough. In fact, I’m still trying to convince her. She’s not totally sold, but a decade and a half later I think I am starting to make good progress. But one thing I know is that that investment pays dividends every single day which is something that no stock or bond will ever do.
¹ – A primary market, such as an IPO, is in fact direct financing of investment spending. This should not be confused with investing though. Investing is still the process by which those funds are then used in the process of spending on future production at the corporate level. On a secondary market, such as the NYSE, almost all trading of stocks and bonds is reallocation of savings and has nothing to do with investment or financing of investment spending.