Where Does Your Money Come From?
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]
Nice post. I have the same philosophy as yours. I don’t buy shares to make a quick profit but rather invest in the underlying business for long term income and capital appreciation. I prefer not having to sell my shares ever, but every now and then even good companies can run into trouble. A recent example is Wells Fargo, I had to sell my shares mainly because their business ethics violated my core investment principles. The only other times I would sell my shares is when stock is grossly overvalued exceeding my max portfolio % limit or fundamentals deteriorate. Otherwise, I will keep my shares forever and keep collecting dividends to fund my income or reinvest.
I don’t think the story is completely written on Wells Fargo yet. There’s more to that story yet to come.
Great article – as usual!
My wife and I have 8 income streams – none spectacular, certainly none flashy (index funds), and while some might rise or fall with the tide they should keep our quiet little lifestyle afloat for life. Mostly we live a quiet, conservative and frugal lifestyle – that’s how we “made it”.
Not sure where my early retirement public employee pension fits in your categories. Retired at 52 – after 30 years. I suppose it is job income set aside and invested in investments on my behalf. Category 1 1/2? That’s roughly 40% of our base anyway. 40% investments, 20% trading – which is essentially stored excess capital tied up in a paid off house soon to be downsized. And finally, yes, arbitrage – it funds my hobbies and is a hobby in itself. I sell high end backpacks on e-bay of all things – I fell into it.
I know this blog is intended for younger people – I tremendously enjoy it anyway. Had there been the high quality of information 20 years ago that is available on the web now I could have done better. Plenty of mistakes along the way. Thanks to Mr.Tako, MMM, Frugalwoods, etc. young people – you have no excuses!
Great article and a good focus on back to the basics.
75% of my income comes from working and 25% is from business earnings, this is on an after tax basis. Fortunately the 25% of business earnings is just enough to cover our household expenses which means the income all gets plowed back into investments. This is because we expect to raise our expenses as school fees kick in and we are also trying for another child.
Best,
Mike
Great points! There was a time when I traded, but I learned better and now I only invest. Unless you have some inside knowledge it’s only gambling – someone has to lose money for another person win some.
That’s a good question.
I guess it depends upon if the earnings impairment is short term or not. One way to think about this is to determine the average return on capital throughout the business cycle.
If the business earns good returns on average I probably wouldn’t bother selling…you might even think about buying more!
If the business is only worth owning through the “good parts” of the cycle, then essentially you’re trying to time the market to catch only that part of the business cycle. Good luck with that.
If the impairment is permanent (i.e. the world has permanently changed) it might be worth thinking about selling if you can deploy that capital someplace better.
In the case of Wells Fargo, I doubt the impairment will be permanent. Banking (in general) is a very good business throughout the cycle. Dividends probably won’t be cut. So I would continue to hold and buy more if good opportunities present themselves.
Remember: The stock price itself contains no information about the future of your investment. Don’t let the price movement of a very tiny percentage of shares impair your thinking about the big picture.
I really enjoyed reading this post. There was a time at the beginning of my “stock market career” when I was a trader. And by trader I mean buying stocks high and selling them low, burning myself with turbos etc. Even though I lost a lot (comparing to the amounts I was playing with) , it was a good investment as I learned a lot about what not to do. Now I’m only focusing on how to generate a stable, passive income stream on a long term. I’m at the very beginning and the dividend income is still insignificant. But I guess you also started somewhere Mr Tako, didn’t you? 🙂 Anyway, blogs like this are really inspirational and help to see the light at the end of the tunnel!
I know many just believe in Total return. But, I like Dividends because they return part of the profit as it is earned and I think, that makes them less risky. Companies that “keep” all of the profit at times get in to trouble (Wells) and you may never get to share in any of the profit, but just the losses. Personally, I think Wells well end up being fine, but I do wish there was more accountability. If some CEOs actually felt some serious pain from companies’ malfeasance, there would probably be a lot more honest dealing companies.
cd :O)
Haha – you’re actually the guy that I DO want to hang out with at the parties… loosen things up a little bit! I like watching that uncomfortableness start to unfold!
When I was younger, I was one of those guys buying just because I liked a company. Granted, I’ve been pretty lucky with some good picks like Amazon and Google, but I haven’t made any money yet since I haven’t sold them and they don’t dish out dividends. And I have quite a number of them out there. It’s actually been on my mind to sell those off (I might do that tomorrow) and put the money in index funds or solid dividend stocks.
— Jim
Love dividends I was a slow learner if I knew what I was doing between 2001 and 2008 I would be a lot better off.
Now he tells me, I always thought that money grew on trees…..;-)
Hi! Great post. I’m young at 26 but already thinking about FI. I, also, invest long term. The money I’m investing in my taxable brokerage account is for the long term. Right now my goal for the end of the year is to accumulate enough index funds in the brokerage fund to produce $1000 in dividends in 2017. I’m on track to have enough index funds to generate $1000 in dividends next year. Next year, I will try to bump it up to $2000 for 2018. And so on and so on.
great goal! I like using dividends as a measure since that’s what I will use once retired. Good luck!
I must say, most informative and great article as usual, really each method of making money is explained briefly and solved my many questions which had been stuck in my mind from ages.
My sources of income
1. Fiverr: A heaven of free Lancers and made me financially independent.
2. Uber: Another great way to make money.
3. Google Adsense: Nothing bests Adsense in ad services.
Keep producing more articles like this, have a good day!
My current income is 90% working for others, 9% working for myself, and 1% investment returns. Depending on how the timing of my skill-building goes, these numbers will change dramatically.
I hate that guy at the party who has a lot to say about how smart he is, but can’t answer a simple question about the topic. Thankfully, excusing myself to the ladies room is perfectly acceptable as a response to boorish behavior.