Have you ever been to one of those parties where people discuss investing? Maybe one of the guests has the audacity to brag about big stock market gains. Do you congratulate him (or her) on that success? Do you share some of your own profitable investments? Or, do you keep quiet and let the braggart continue their boasting?
Back in 2007, I found myself at such a party. This was during the height of real estate mania and a booming stock market. Asset values were high, and nearly anyone with investments was doing well.
At this party was an acquaintance of mine (of considerable wealth). After a few drinks his lips were loosened, and he started talking about the big investment gains he’d been making by trading shares in his favorite stock — American Movil (stock symbol: AMX).
Most of us in North America have probably never heard of American Movil, but if you live south of the border it’s a pretty big deal.
American Movil’s business is primarily cellular phone service, with operations all over Latin America. At one time AMX controlled 70% of the Mexican telecom market. American Movil enjoyed monopolies in many South American countries. Competition was minimal, and profits were very good.
Anyway, back to the party…
So I’m standing there listening to him brag about his 100% return in a year, and I decide to ask a few questions about AMX. Mostly because I was unfamiliar with the business.
Unfortunately, he couldn’t really tell me anything about the business. His entire investment thesis was, “Cell phones are getting more popular in South America. I’m bound to do well.” Beyond his thesis, he had very little true knowledge of the business operations.
Frustrated, I thought to myself, “He has no idea why this investment is successful. All he knows is that the stock price is going up.”
Instead of being rude, I decided to ask him a simple question, “You’re doing really well. That’s great! So where exactly is your money coming from?“
He looked at me for a moment, and then answered, “What do you mean? When I sell the shares I receive money. Doesn’t that come from the stock market?“
“You’re right” I said, “It’s the greater fool theory. The money comes from someone in the market buying your shares. None of your gains are from the business itself. What happens when the market turns and there aren’t any investors willing to pay those prices? How will you make money then?“
Needless to say, I’m not terribly popular at parties. (Maybe I should start drinking)
My gentle warning ended up being startlingly prescient. In 2007 AMX’s price per share hit highs that it would never see again. American Movil’s monopolies were broken with new legislation in several countries. AMX’s price per share would drop from $30/share in 2007 to just over $11/share today. In 2008, dividends were cut in half, and have continued to decline ever since.
The Dangers of Trading In Markets
At the time of the party, I had no idea the governments of Latin America would begin cracking down on AMX’s monopolies. I didn’t have a crystal ball that was predict this would happen. What I did have was knowledge.
It was pretty obvious that returns of 100% annually wouldn’t continue forever — Trading profits like that are rarely continuous, and few humans can capture profits like that with any regularity.
Trading is one of the more difficult ways to make money. The market itself is unpredictable. One day Mr. Market is in a happy mood and setting new highs. The next day Mr. Market could be in a bad mood. It’s impossible to tell which way the wind is going to blow. The market could stay mostly flat for decades. As we discussed in My Financial Independence Failure, this has actually happened in some countries.
History is a great teacher about what’s possible for the market. I highly recommend reading the classic “Manias, Panics, and Crashes: A History of Financial Crises” for a little self education on market history.
The book is a look at wild market swings, starting from the 17th century all the way up to the last Great Recession. It should be required reading before anyone invests in the stock market. Sadly, it is not.
Deriving income from the stock market can be a pretty risky proposition, but it’s also very fashionable these days.
Nearly everyone in the modern world throws money into the market hoping the market will rise. What if it doesn’t? Will you really rely on fashion to fund your retirement?
History tells us that as economic activity grows, so should the collective value of our markets. History also tells us that economies can go through periods of stagnation where markets fail to rise for long periods of time.
Stagnation. Sound familiar to anyone?
How To Make Money
If trading is inherently risky and unpredictable, how can Financially Independent people make money that isn’t tied to the movement of markets?
There really are only 5 (honest) methods of making money in this world:
1. Job Income is the trading time and labor in exchange for money. Job Income isn’t my favorite way to make money, but it is the most popular method. Having a job also takes a lot of time. If you’re reading this, I’m going to assume Job Income isn’t really your main goal. I would hazard a guess that finding forms of income outside of a job is more along your lines of thinking.
2. Trading is the buying of “goods” at a low price and later selling at a higher price. It’s a way of deriving income from the market. Sometimes called “the greater fool theory”, because a bigger fool than you is required to make profits. The unpredictable nature of markets make this one difficult to utilize without eventual losses. Everything could go great for awhile….and then one day the market turns against you.
3. Arbitrage is a fancy $10 word for exploiting price differentials in different markets to realize profits. An example might be buying stuff at garage sales and then reselling it on ebay. That’s arbitrage. Exploiting low prices in one market (garage sales) and then selling in another market (ebay). It does take considerable knowledge and skill to find these opportunities, and very rarely are they constant. I would never pay my regular expenses with this income.
4. Interest income is money earned from the loaning of money with interest. Primarily this income is derived from bonds, bank interest, and personal loans. While it is a entirely valid way of earning money with capital, this income source is suffering through a period of terrible returns. Government treasuries return less than 2.5% on your dollar. It’s safe to say that earning interest income is far tougher than it used to be.
5. Business Earnings are the income generated from business profits in excess of business expenses. Whether it’s from rental property, small business earnings, or even dividends from larger businesses. Business earnings are my favorite source of income. One of the key advantages of business earnings is that they aren’t reliant on market movements to create income. There’s no “greater fool” required to buy-out your interest in order to make money here. Business earnings are made by serving customers and realizing the rewards as an Owner.
How Do You Want to Make Money?
So now it’s time for me to ask you that question: Where is your money going to come from?
Will you rely on the “greater fool theory” to fund your retirement? Will you rely on the crowd to keep throwing money into the market, causing rising prices?
Or, perhaps you want business earnings from companies you own. Companies that earn good returns on capital. Earnings made from people going to work everyday — to pay the bills, and feed the family.
By now, I think my answer to that question is pretty obvious. I’ve ranted and raved about it in numerous posts. Maybe I’m just beating a dead horse, but I think the concept is important.
The market might rise 10% tomorrow, drop 10% tomorrow, or even stay flat for a decade. We just don’t know.
But I do have a pretty good idea that everyone is going to put their pants on from Monday to Friday and head to work. This is one of the reasons why I have a big focus on dividends — because dividends are business earnings.
The market will do what it does (anything), but well run companies will continue to generate earnings, invest cash, buy back shares, and pay dividends despite the market swings.
I often talk about investing in common stocks, but isn’t that just investing in the stock market?
Not the way I do it.
I don’t buy “the market” when I buy common stocks. I use the market as an affordable way to buy businesses. If I was to buy private businesses of the same quality in private market, I would never be able to afford them. The price would be astronomical!!!
Instead, I buy my small piece of ownership and never look back.
To me, daily market price quotes are pretty much meaningless. Someone is offering to buy or sell to me at that price. I take advantage only when the prices suit me.
My philosophy is to earn my money from businesses, not “the market”. I intend to hold most of my businesses for a decade or even longer. In a situation like that, the market is practically irrelevant.
Eventually the market is supposed to reflect the business truths…but it could take decades for that to happen. I’ll be a happy camper collecting those business earnings in the meantime.
How about you?
[Image Credit: Flickr]