Monday, June 22, 2009

Investing or Gambling?

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Some folks at church were teasing Doug about being a stockbroker, implying that he was facilitating gambling. Finally He responded, “Hey, I look at it this way. The brokerage firm makes money, the broker makes money, and two out of three ain’t bad.”

So is it gambling to buy stock? It can be, in either investing or gambling there is the possibility of either a loss or a gain. However the big difference between the stock market and most gambling is that in the stock market there is a possibility of actually creating wealth. That doesn’t happen in a casino, weekly poker game, or a state lottery. Let’s look at three different cases:

1. Zeke plays poker with three friends every week.

2. John buys a lottery ticket every week, and

3. Willie invests in the stock market.

Zeke’s poker game is what is called a zero-sum game. At the end of each poker game, money will have changed hands. There will be winners and losers. However the total amount of money they all have will remain unchanged (except what they spend on refreshments etc.). Wins minus loses total up to zero, hence the term zero-sum game. In terms of expectations, Zeke’s expectation is zero assuming all the poker players are equally skilled.

John’s lottery ticket is something much worse than a zero-sum game. If you add up all the winnings of all the winning tickets, it will be less than the total of what people paid to buy tickets. The rest goes to the state, to the retailers, and to the company that runs the lottery. There is a net transfer of wealth away from the players leaving them poorer in the aggregate. This is actually a negative-sum game since subtracting all the losses (ticket purchases) from all the winnings gives a negative number. The same thing happens in casinos and other venues where the house takes a share. Lotteries and casinos are sucker-bait. The expectation from playing them is negative.

Willie’s situation is more complicated. He becomes part owner of the companies in which he invests. If he invests in a new company, that company will take his money and use it to create products or services they hope people will want to buy. If the company does that well, Willie’s investment will grow and he can reap the rewards of either part of the profits (dividends) or an increase in the value of his stock. If all goes well, Willie gains, the company gains and even the customers gain from the availability of something they want. Willie’s investment has actually created wealth, not just moved it from one pocket to another. In a wise investment, expectation can be positive.

But what if Willie buys stock in an existing company? The company is already in business; can buying its stock create wealth? Actually it can, and in two different ways:

First, an existing company may issue extra stock to get the money for expansion. That can allow it to acquire new facilities and equipment, hire more people and provide its products to more customers. If those customers are happy with the product everybody benefits, except maybe the company’s competitors. Again wealth is created.

Second, what about the initial investors in that existing company? The time may come when they no longer want to own part of the company. They may need the money for retirement, to send the kids to college or some other purpose. They are unlikely to make the initial investment unless they see a way to sell their share of the company when they need to do so. That is what the stock market is for, it provides a convenient way to buy and sell little pieces of big companies. That encourages people to invest and help create wealth. The possibility that Willie would buy stock today helped encourage someone to make an initial investment years ago.

Of course Willie should be careful how he invests his money. In George Samuel Clason’s parable “The Richest Man in Babylon,” Arkad, the protagonist, first trusts his investment to a brickmaker who is going to travel and use it to buy jewels. Of course the brickmaker knows nothing about jewelry and gets cheated. Arkad loses his investment but learns from the experience. Next time he invests with a shieldmaker who uses it to buy bronze for shields. Now he has invested with someone who knows what he’s doing so he makes money. Later when asked about taking advice from brickmakers, Arkad replies that they give good advice – about making bricks.

Our economy today is more complicated than that of Babylon. Instead of brickmakers and shieldmakers we have technology companies, large retailers, automotive companies and on and on and on. Some are good investments and some are not but the basics are the same as what Arkad learned. Invest with someone competent and who can provide a product at a fair price that will satisfy customers and turn a profit.

Of course one result of the complexity of our society is that we can never be certain any particular company will do well. New technology may make their product obsolete, or a competitor may find a more efficient way to produce that product. That is why it is sound policy to diversify investments. One company, or even one sector of companies, may fold because of changing conditions. For example, suppose you had invested in the Pony Express or another company to compete with them. You might have done well for a couple of years but then the telegraph would have made your investment worthless.

The point is that, aside from investing in quality companies it is wise to diversify your investments. Of course most of us don’t have enough money to buy stock in very many companies, nor do we have the time to research those companies. What to do? That is why various types of mutual funds, exchange traded funds, index funds, etc. exist. They pool the money from many investors and buy stock in many different companies. Some will do well, some will not, but there is a good chance that the total will be positive and very little chance that investors will lose all their money.

For most people such funds are the safest way to invest. True, you don’t get the large gains you would if you invested all your money in a company that took off like Microsoft did. However neither do you have as much of a chance of losing your entire investment if the one company you picked goes belly-up. Think about the utility to you of a big gain compared to the utility you will lose if you take a big loss.

I’ll even toss in here my personal recommendation for the average investor. I think most people should buy index funds. They are very diversified and have low overhead. Regular mutual funds charge a management fee for the expertise of the people picking the stocks to invest in. I’m not convinced that those experts are really worth the amount they charge. By the time investors pay their salaries and overhead, the trading expenses etc. they eat up a large part of the gains. Index funds have little such expense; they just buy the stock listed on one of the major indexes. I recommend an index with a lot of companies in it to get better diversity.

This is a big subject and of course I’ve not covered it all here, nor will I. However in the next blog I do intend to discuss a trap that catches lots of gamblers and investors. I’ll do that tomorrow if all goes well.

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