You Are Not An Investor‏

You are not an investor. You might think that you are, but you are not. And that is a good thing.

Saving Versus Investing 

You are, or should aim to be, a saver. If you earn more than you spend over a period of time, then you have a surplus. That excess is your savings, and you have various choices about what to do with those savings.

Investing is something different.  In an economic sense, an investment is the purchase of something that is not consumed today but is used in the future to create wealth. Standard examples are starting or expanding a business, the hiring of workers or the building of a factory.

When most people talk about “investing” in stocks and bonds, they are not investing in any meaningful sense. Instead, they are allocating their savings towards the financial markets, hoping to preserve capital and maybe make a return. Despite its branding as “investment” by the financial industry, allocating savings towards the secondary market is not the same thing as providing capital for companies to grow.

In a secondary market like the NYSE or the NASDAQ, the cash does not go to the company whose share you purchased: it goes to the person who previously held that stock. When you spend $540 on a share of $APPL, that money does not go towards building factories, or hiring designers and salespeople. It goes to the person who previously owned the share. The only time that the money goes to the actual company is during IPOs and subsequent issues, which are a small proportion of overall transactions.

Why Does This Distinction Matter?

Secondary markets are great: I trade on them regularly. But to describe your savings as investments is to put the cart before the horse. It might make sense to allocate some of your savings towards investments, but that is only one of a range of options.

By focusing on your “savings portfolio”, rather than an “investment portfolio”, you can change the emphasis and priorities. By being clear about what you are actually trying to achieve, you can start to obtain a better result.

Cullen Roche believes that your savings portfolio should achieve two primary purposes:

1. It should protect against the potential for permanent loss.

2. It should reduce the risk of purchasing power loss.

I phrase it slightly differently, but with the same overall idea:

The goal of the individual saver should be achieving high risk-adjusted returns, net of fees, taxes and inflation.

Directing your savings towards traditional “investments” might be a suitable way to achieve those goals, but it might not be. You also have other options of what to do with your savings, and the financial industry does not have the same goals as you.

The financial industry loves to sell you the idea that you should “invest”, since that helps persuade you to buy their products. And then sell their products. And then buy slightly different products, all in the hope of a higher return.

Even better, you should hand over some of your savings to them to “invest”, so they can charge you asset management and advisory fees on top of transaction fees. This level of churning and fees is great for them, but murder for your savings.

The Bad News

Their fees might be worth paying, if you could beat the game and consistently earn high risk-adjusted returns, net of fees, taxes and inflation.  The problem is you are not very well set up to do this. We might be in the golden age of the individual investor, but you are still poorly positioned relative to the news flow and order book.

Succeeding requires the right capital structure, which you are unlikely to have. One of the many things Warren Buffett got right was to recognize the importance of the right legal and operational setup. A permanent capital base, where there is little danger of sudden redemptions, is a priceless asset in taking advantages of the changing moods of Mr. Market. To be able to withstand the volatility rollercoaster without getting blown off course requires a patient and unleveraged capital base that can pick off bargains when they show up.

You are not that patient and unleveraged capital base. Any margin loans, mortgages, student loans or credit cards in your immediate family group should be viewed as leveraging your overall portfolio. Add in your unpredictable cash-flow requirements, and you are not well set up to handle the 100-year storms that hit the financial markets every seven years or so.

On top of that, we all have flawed and emotional monkey brains that let us down at the worst possible time. All of your decisions and non-decisions are influenced by your emotional and logical biases, and they will encourage you to do all the wrong things at all the wrong times. You will hold your losers, sell your winners, panic in draw-downs and seek out evidence that confirms what you already believe. You can tell yourself that you are the one person who will not act that way, but that is an emotional bias too.

You are not an investor. You are, perhaps, an over-leveraged trader with unacknowledged cognitive biases and poor risk management.

The Good News 

Here is the good news. If you ignore the relentless hype of the thundering herd, then you can escape the fees and the transaction-obsession and instead focus on making good risk-adjusted decisions on the portfolio of your life.

For example, paying off your family debts is a must: often, by far the best risk and tax-adjusted return you can find is paying off your debt. Debt is an emergency, and paying it off is a far higher priority than “investing” in mutual funds.

Building up reserves is a solid idea: not just financial reserves, but real supplies of essential items as well. Investing in your skills can pay dividends at work and at home. Finding savings and negotiating discounts is as real as money made in the stock market, and a far better risk-adjusted return.

Best of all, you can get a very high rate of return by spending time on things you actually enjoy and with your family, especially your children. Children thrive under the careful attention of well-rested adults. The return you receive in helping them develop into self-confident, grounded and productive adults is likely to be higher than the return on an ETF. If you are after a solid challenge to your lifestyle choice, I suggest you go meet Mr. Money Mustache.

You are not an investor, you are a saver. And that is good, because you are not very well positioned to be a successful investor, but you are well positioned to be a great saver.

You Are Naturally Short Housing

Your house is not an asset. It is a hedge.

You are born with a natural short housing position. For the rest of your life, you will need somewhere to live. Ideally, somewhere with a roof. To use a (slightly tortured) trading analogy, you are born with a short housing position.

There are several ways to cover this short. In the beginning, your parents usually pay it for you.  Once you are on your own, you have various options that can generally be divided up into two categories:

  • A floating rate (e.g. a short-term lease)
  • A fixed rate (e.g. a long-term lease or a house purchase)

The best option for you will depend on many things e.g. the relative cost of renting v. owning, your need to be geographically flexible (i.e. your liquidity requirement), your ability to obtain credit etc. There is not necessarily a “correct” answer. I have done both at various times of my life.

Whatever option you choose, however, you need to understand that you are only covering a short position. If you choose to buy a house, you are not going long the housing market. You are going flat the housing market using a fixed rate product to lock in your exposure.

If house prices rise, the value of your house (the hedge) increases but so does the cost of shelter, which you are always going to need. If house prices fall, your home loses value, but the cost of shelter falls.

Why does this distinction matter? Because if you purchase a house, you should not fall into the trap of getting excited when house prices rise. You should especially not fall into the trap of borrowing against the rising value of your house (your hedge) to fund increased consumption.

Think about it this way.  Imagine if a gold producer used the futures market to hedge future production and lock in a sales price. If the gold price fell (not that it ever will, of course. Fiat money and all that), then the producer would have a gain on its hedge.

However, that gain would be offset by the fact that they can only sell their production at a lower price. If the producer borrowed against that gain in the hedge to buy jet-skis and a winter chalet in Vermont, it would be clear that they were taking a massive gamble.

The same thing applies to your house. If you buy a house, you have covered a short rather than gone long. This means that you need to be very careful about borrowing against that hedge, and even about counting your house value as part of your total assets.

This is hard to do, since a house is usually a large part of someone’s assets, and it is tempting to include it when counting up retirement assets. Except that you still have a natural housing short when you are 66. Sure, you can downsize your house, but then you are playing more of a big house/small house spread game.

You are born naturally short shelter. Your house is not an asset. It is a hedge.

It’s Not Saving Unless You Spend Less‏

Continuing my brief tangent into personal finance, here is an anecdote that brought home an important point to me in an amusingly drunken way.

Some months ago, I was in a bar with a large group of individuals, and someone was ordering shots for everyone. The barman offered to sell us the bottle. Having quickly done the math (we were all clever, arrogant, finance-types) we realized that it would be cheaper to buy the bottle than to buy the equivalent volume one shot at a time. Bargain, right?

Someone described this as “saving money”.

False. It not saving money unless you spend less.

For sure, we got a lower per unit cost. If we were already going to consume the volume equivalent of one bottle, then it might have been saving money. But we had not yet decided to consume that much volume. By making us focus on the per unit cost, the barman persuaded us (remarkably easily) to dramatically increase our total volume, and to spend a larger amount of money than we otherwise might have.

The per unit cost is important, but it is not “saving money” unless the amount of cash being handed over goes down.

The True Implications Of Being Short Gamma

A Thanksgiving Treat. Spot the similarities between the two graphs.

Graph 1, the well-being of a turkey across time:

Source: Attain Capital

Graph 2, the equity curve of our old friends at Long-Term Capital Management:

Source: Wikipedia

For turkeys and gamma sellers alike, everything seems fine until one day….

Avoid Moving Money From The Many To The Few

Occasionally I get asked if I know of any “good stocks or investments” to invest in. Since I am a trader by career and by nature, my answer may surprise you: most people should stay away from the stock and bond markets.

The financial markets are very efficient machines for moving money from the many to the few. The brokerage and money-management industries are very good at extracting fees and margins. They are explicitly designed to deliver “alpha” for them rather than for you.

The goal of the individual investor should be achieving high risk-adjusted returns, net of fees, taxes and inflation. It is very difficult for your average retail investor to achieve a reasonable rate of return on capital via the stock and bond markets, especially when adjusted for the risks you are taking and the taxes and fees you will pay.

There are other ways you can achieve high returns on your excess cash, without incurring the fees and risks of Wall Street. You often will not hear these options recommended by anyone who gets paid based on transactions, fees or a percent of assets, but they often offer the best risk-adjusted returns, net of fees, taxes and inflation.

Here are my standard suggestions:

Pay Off Your Personal Debts.

Most Americans have debt: mortgages, credit cards, student loans, car payments. Often, by far the best risk and tax-adjusted return you can find is paying off your debt.

For example, if you are paying 5% on your mortgage, you need to find an investment where you are earning a guaranteed return in excess of 5% after tax  and after fees in order to justify not paying your mortgage off. That type of return is very difficult to come by, especially part-time. For the academically minded, the appropriate “risk-free rate of return” for most individuals is not T-Bills, but their highest interest rate.

I have met people who have some cash savings, some stocks, some bonds and an 18% credit card balance. Sometimes with the same financial institution. Holy ****. Someone is making money there, and it ain’t them.

Living in debt is generally a poor financial decision, and severely inhibits your ability to operate as a free citizen. Prioritize paying off your debts as fast as you can, and especially pay off your debts before you invest in a mutual fund. Just do it. As Mr. Money Mustache puts it:

Your debt is not something you “work on”. It is a huge, flaming emergency!!!

Spend Less And Save More

Tadas Viskanta says that “savings is the best investment”:

It is far easier to generate additional savings through more conscious consumption than it is to generate additional returns, or alpha, from the financial markets. So starting early with a dedicated plan to live below your means is an important part of any comprehensive financial plan.

How much you have saved up for retirement is dominated by one thing: your savings rate. A study by the Putnam Institute, reviewed by Reuters, examined how a hypothetical saver would have fared over the last thirty years if they had made a variety of decisions regarding fund selection, asset allocation, rebalancing and saving. Even a “crystal ball” scenario that assumed you could see the future was outperformed by an increased savings rate:

Interestingly, even a 4 percent deferral – which represents a 1 percent increase that does not take advantage of the plan’s full matching contribution – would have had a wealth accumulation impact 30 percent larger than the crystal ball fund selection strategy, nearly 100 percent larger than the growth allocation strategy, and approximately 2,000 percent larger than rebalancing.

Fund selection, investment return and asset allocation are flies on the back of the elephant in the room compared to how much you save every month.

Build A Reserve

Beyond the usual advice to have 3-6 months of your salary saved up in case you lose your job, you should also use your free cash flow to build up supplies and surpluses of essential items. This partly helps you achieve efficiencies from buying in bulk, but also provides a real margin of safety for you and your family should the services we rely on break down. A larder full of 3-6 months of food and essentials is a better investment than most bonds.

Negotiate Discounts

Once you have some free cash flow, you can take advantage of your ability to buy in bulk and negotiate discounts. Most retailers will give you 5 – 10% discounts for buying in bulk and/or paying in cash. Saving 10% on your grocery bill in the equivalent of a 10% return on an asset, free of taxes, fees and risk. As Mark Cuban says, become an efficient consumer.

Invest In Yourself

For most people, their main income is their salary. If you can do something that gets you a 5% pay rise, then that is often a very high rate of return on the money spent. That could be a training course, it could be something that allows you to get 1 hour more sleep a night so you are more productive, it could be learning to play golf so you can become friends with the boss.

Invest In Your Family

You can get a very high rate of return on investment by spending time with your family, especially your children. Children thrive under the careful attention of well-rested adults. If you have paid off your debts, it is seriously worth considering if you or your spouse can take time away from your careers and focus on your children. The return you receive in helping them develop into self-confident, grounded and productive adults is likely to be higher than the return on a mutual fund.

The brokerage and money-management industry have a vested interest in encouraging you to engage their services. There are times when their services can be useful to you, but you should not believe that everyone needs what they have to sell.

The goal of the individual investor should be achieving high risk-adjusted returns, net of fees, taxes and inflation. There are a number of things that meet those criteria better than the standard repertoire of mutual funds and ETFs. You should do all of these things before you even consider investing and trading.