The inspiration for this post comes from questions that show confusion over investing versus speculating.
Investing, in it’s purest form; is where you put up capital (Money), and you expect a reasonable return on the investment. The return is what is paid to you as a form of profit for your business, or if you are investing in an established business; it is a payment for putting your money at risk.
Risk is where the possibility exists that you could lose a portion or all of the money you invested. This is why there is an expectation of ROI (Return on Investment). The best investments that I have found are investments with asymetrical risk; where there is limited downside risk, but large upside potential. An example of this would be buying pennies. The copper in a penny is worth 0.018 cents; so you could theoretically buy a penny for 0.01 and resell the copper for 0.018 (Note that it is illegal in the U.S to melt nickels and pennies and this is just being being used as an example).
What comparisons should be made when evaluating the potential returns on investment? One of the key elements of return is timing; when should I expect a return on investment because a dollar today is worth more than a dollar tomorrow. For example; a real estate holding may pay monthly at an agreed upon rate that should meet your ROI expectations. Johnson and Johnson pays a steady dividend every quarter that hovers around 3%; whereas Disney pays a dividend once or twice per year.
Notice how I am speaking solely about dividends and rental payments above. I am not speaking about real estate or stock appreciation. Monthly rental payments and dividends are predictable; capital gains are not. Capital gains happen more frequently than capital losses as we have been in a bull market for ten years now, but when losses happen; they often hit hard; not to mention the intermittent volatility that comes with stock or real estate constantly bobbing up and down.
This is now a great segue into speculation. Donald Trump (love him or hate him) wrote in The Art of the Deal:
Unlike the real estate evangelists you see all over television these days, I can’t promise you that following the precepts I’m about to offer you’ll become a millionaire overnight. Unfortunately, life rarely works that way, and most people who try to get rich quick end up going broke instead.
I am inclined to agree with him in that many day traders and house flippers go broke. You can not reliably predict which way the market will head minute over minute. In this sense; day trading or property flipping is a full time business because it requires constant vigilance and these assets can not be held very long; or in many cases, not even held overnight. This is called speculating, or as I refer to it; gambling. Some people can accumulate large sums of money doing this, but it is not for everyone and comes with massive and unpredictable risk. Some companies even set up automation to buy and sell in high volumes at certain price point triggers, unfortunately, when you rely on computers to do your dirty work; you can end up like Knight Capital losing $10 Million per minute.
So when you invest; you need to make sure you have certain time commitments in place and have a reasonable understanding of what your return will be. If you enter into a position and have no idea what you will get out of it; you are speculating. You need to understand your return, your risk, and the timing of the two. In 2015, I purchased 20 shares of Johnson and Johnson for $ 2,070. Today those shares are worth $2,535; a 22% gain. But my risk is still 2,070; if JnJ were to hypothetically go out of business tomorrow; my total risk is $2,070. More importantly to me though is the $228 that JnJ has given me to date to keep that 2,070 at risk. This 10% investment to date return is more important to me than the 22% capital gain. The $18 (as of 2018 – $16 in 2015) that JnJ gives me every three months is reliable and predictable.
There is obviously some added complexity to this if you are interested in real estate such as things like the IRR (Internal Rate of return). For any type of investment there is the RRR (Real Rate of Return), which compares to inflation. Then there are also comparisons to be made to the risk free rate. More on these in later posts.
Do you understand core tenets of investing now?
Disclosure: I currently hold shares of (NYSE:JNJ). I do not plan to sell or acquire more positions in the next 60 days.