The majority of investors in the stock market do not realize that they are speculators and think that they are investors. When exposed to investing in a businesslike fashion, they might agree that it makes sense to treat stocks as pieces of businesses and to buy them only when getting a deal, which means purchasing stocks for less than they are worth. In their minds, this kind of approach is logical and makes sense, but what happens in practice is a completely different story.
An investor in a private business transaction handles his or her investment differently than an investor in public securities. After closing on a private business transaction, the buyer of a convenience store or an apartment building begins strategizing how to increase sales and cut unnecessary expenses. The questions he or she will likely ask are the following:
- How can I attract more tenants to my apartment building?
- How can I make my convenience store more visible from the street so that more drivers stop by?
- Are my marketing dollars getting me the most bang for the buck?
- Are my employees working efficiently?
Let us assume that there were eight bidders at the table willing to purchase this business before a buyer was chosen. Do you think that the buyer would go back to the losing bidders and ask them the following question?
- As you may know, I closed on the business a week ago. What would you be willing to pay for this business today?
If the buyer did ask this question, the other bidders would likely have told him that nothing really changed about the business so their offering prices remain the same.
However, in the public markets, after purchasing pieces of businesses, investors log in to their computers the next day and check the stock price to evaluate how they are doing. In a sense, they are going back to the other bidders and asking them what they would pay for the business the next day. If the other bidders are willing to pay more, the stock price increases. As a result, investors feel great about their superior investing skills. They usually do not forget to tell their friends about it either. On the other hand, if the other bidders have a bad day and are not willing to pay as much for the business as they did the previous day, the stock price decreases. As a result, investors start to feel nervous. This time, they most definitely choose not to tell their friends about it. Instead, they start looking for reasons for the decline. It must be the Federal Reserve’s decision to increase the interest rates. Or maybe it is the debt crisis in Greece. No, the reason has to be that the 200-day moving average hit a certain level. Instead of focusing on the underlying business that the stock represents, they focus on everything but the business. Then they start buying and selling based on what everyone else is doing. In other words, they start speculating, which is guessing what other market participants are going to do in the future. Benjamin Graham said that “In the short run the stock market is a voting machine; in the long run it is a weighing machine.” Speculators are trying to figure out how the stock market will vote on particular businesses in the short run. Instead of studying businesses, they focus mainly on price by attempting to understand market psychology. They use tools such as technical analysis, which assists them in studying supply and demand with charts as the primary tool. If they think that the price of a security will increase, they will buy it despite the underlying business. If they think that the price of a security will decline, they will sell.
It may be hard to believe that intelligent people can act in such a way, but this is how the stock market operates on a daily basis. It is challenging enough to stay disciplined and patient when investing your own money; the difficulty level is magnified when investing someone else’s money.
If you ask an investment banker what the benefits are for taking a private business public, one of the responses will be the increased liquidity, which means that the owner can exchange the ownership interest in the business with the click of a mouse. However, what really happens is that the ease of ownership exchange transitions people from true owners into speculators. The sad part is that it happens without people being aware of it. The speculative nature of public markets is unlikely to change especially because the majority of funds are professionally managed and the pressures for short-term performance are enormous. The market participants who truly understand what investing is and have discipline and patience to stick to it will have an edge.
The definition of investing differs depending on the source used. Some say that investing is how you make money grow or how you put your money to work for you in such a way that it is likely to generate more money. Under definitions like these, gambling qualifies as investing because anyone can say that placing money in the slot machines is investing in the event of a win. One of my favorite definitions of investing can be found in The Detective and The Investor, a book by Robert G. Hagstrom. According to Hagstrom,
“Investing is the process of calculating the economic return of an asset over the life of the asset. This process has two parts. The first seeks to determine the fundamental return that the asset will yield, based on its underlying economics; the second adds to or subtracts from this return based on the price paid for the asset.”
What does this mean in simpler terms?
Let us first examine the fundamental return of an asset. For example, you decide to go into the business of selling hot dogs on the corner of two busy streets. Before you can start making big bucks, you have to acquire a permit and license; purchase a hot dog stand; buy buns, hot dogs and other supplies; find and pay for a space in which to operate; and hire employees. If by the end of the year, you spent $10,000 and you generate $1,000 in profit, then the fundamental return on your invested money is 10 percent ($1,000/$10,000). However, the fundamental return can be different from the overall return because it is dependent on price. For example, if for some reason you decide that you do not want to own your hot dog stand that is generating $1,000 of profit per year, you might sell it to a third party. If the new buyer pays $10,000 for your business, he or she will earn a return of 10 percent (10 percent = $1,000/$10,000). If the new buyer pays less than $10,000 for your business, then he or she will earn a return that is higher than the fundamental return of the business, which in our case is 10 percent. If the new buyer pays more than $10,000 for your business, then he or she will earn a return that is lower than the fundamental return of the business.
To summarize, investing is determining the fundamental returns of individual businesses and purchasing them at prices that allow us to earn returns that we are seeking. To do this successfully, investors need to understand the businesses and industries in which they invest.
Warren Buffett said, “Investing is simple, but not easy to do.” Because people are constantly being exposed to day-to-day price variations and because they can enter and exit ownership positions with the click of a mouse, investing becomes extremely difficult. Constant temptations to buy and sell turn investors into speculators.