Commentary Magazine


Investing, Then and Now and Always

It sometimes seems that the old-fashioned art of “investing”—putting money into a specific business with the goal of sharing in its profits—has been superseded by sheer financial speculation, often of a rampant and irresponsible sort. Most accounts of profit-seeking activity today dwell on activities on its margins in the form of complex and often incomprehensible financial instruments known as derivatives. In the 15 years preceding the 2008 financial meltdown, the minute-by-minute discussion of stock prices seemed aimed at stimulating day traders, who buy a stock in the morning only to sell it in the afternoon. At the same time, computer programs were set up to take advantage of tiny changes in a company’s position during any given day, thus turning the act of buying and selling stock into something very nearly beyond human agency.

Whatever happened to the commonsense wisdom displayed by, say, Benjamin Graham (1894-1976), the Columbia Business School professor whose name became synonymous with a simple, straightforward, look-for-undervalued-companies-and-hold-them approach?

Well, nothing, actually. Graham’s classic book The Intelligent Investor is, as of this writing, number 289 on the Amazon sales list—not bad for a book first published in 1936. Warren Buffett, the most successful investor in history, is a thoroughgoing Grahamite, and that alone is good advertising for investing instead of speculating.

The truth is that speculators have always received the lion’s share of the press, in good times and bad. Speculation is much more exciting as a subject of discussion, since the results are often known much more quickly. Speculators surf on the waves of risk.

One of the fundamental laws of the marketplace—although one not often enough emphasized—is that risk always equals potential reward. If you buy a lottery ticket, you are at an astronomically high risk of losing your entire investment. But if you guess the right numbers, your reward is equally astronomical. In a country as large as the United States, someone is likely to buy the right ticket and gain, say, $200 million while risking only a dollar. That’s news. The millions who each bet a dollar and lost it are not.

What tide is to water, risk is to the world of finance. It’s omnipresent and always in operation. It can kill you—at least financially—if you aren’t careful, but it can also make life a lot easier if you use it to your advantage. You have to decide how much risk to take on.

Risk is omnipresent because there are no totally safe places to put money, even if you keep it close to you. After all, houses do burn down, taking the money under the mattresses with them. Businesses can go bankrupt and default on their bonds. Just ask the bondholders at GM and Chrysler. Banks go belly up. Governments can always print money to pay off their bondholders, but printing money causes inflation, which wipes out the value of investments denominated in the currency being printed. Middle-class Germans found that out in 1923. And governments can be overthrown and their debts repudiated. Holders of czarist bonds had to begin counting their losses in 1917.

At the other end of the risk spectrum, there are no currently foreseeable circumstances that would cause the U.S. government to default on its bonds. As a result, short-term Treasury bonds right now are paying virtually nothing in interest, and 10-year bonds (much more subject to the unknowns of the future) are paying only a little over 3 percent. Investing $1,000 in hopes of gaining $30 in a year’s time isn’t thrilling enough to generate attention (though given what has happened to real-estate values over the past few years, it doesn’t seem like a bad deal). Still, it would take an investor 24 years to double his net worth at a 3 percent rate of return. Not much to write home about there.

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The difference between gambling, speculation, and investing has to do with where each falls on the continuum of risk. Gambling is the riskiest; investing the least; speculation in the middle.

Strictly speaking, gambling always involves a randomizer—whether cards, dice, horses, or a machine that pops up ping-pong balls with numbers on them. In pure gambling, such as lottery tickets, it’s pure luck that determines the outcome. With games like poker, skill, over time, will determine the winners. But gambling never creates wealth. It only redistributes from the unlucky and unskillful to the lucky and skillful.

The biggest difference between gambling and speculating is gambling’s all-or-nothing aspect. Investing in a lottery ticket is gambling; you win big or you lose everything. But putting your money in gold, for instance, is speculating. You may win or you may lose, but you won’t necessarily lose everything.

Gold, which has almost no industrial or other uses, has no intrinsic value. But many regard it as a good hedge against inflation. If more and more people invest in what is a largely fixed supply—it is unlikely someone will find a colossal new gold mine and flood the market with new material—the price has to go up, which it does whenever inflation seems imminent. In the past 10 years, the price of gold has tripled (in dollar terms). But in the past 30 years, gold has lost a third of its value from its 1980 inflation-induced high. Thus in speculation, timing is everything. If you played a short-term gold game recently, you made a killing. Not so with the long game.

What is the difference between speculating and investing? Successful speculations depend on guessing right on market forces and are usually short term. Investing means putting your money in productive assets, such as a corporation or land, and hoping they will grow in value over time because of the production of wealth.

Investing is basically putting your money in wealth-creating enterprises and waiting for that wealth to be created. While not as exciting as speculation, still less gambling, investing can be very, very profitable. A thousand shares of Microsoft on the day it went public, March 13, 1986, would have cost you $28,000. By March 13, 2000, that investment was worth $7,056,000. The tricky bit, as the Microsoft example demonstrates, is spotting a growth opportunity before the market as a whole does and selling before trouble becomes widely apparent; over the course of the past decade, Microsoft has been relatively flat, while Apple, which looked nearly dead in 1986, has soared.

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All three approaches to risk-taking in the hope of profit have been around since the dawn of civilization. Egyptians played board games, and dice have been found in a 5,000-year-old tomb in what is now Iran. Rome had severe—and universally ignored—laws against gambling. It also had professional gamblers who sometimes used loaded dice. (That’s one way of reducing risk, of course, as long as you don’t get caught.)

Speculating in commodities was common in the ancient world, and people of wealth invested mostly in land. Crassus, who along with Pompey and Caesar formed the First Triumvirate, was one of the richest men in Rome and had invested heavily in silver mines as well as in land. He also owned a fire company. When someone’s property caught on fire, he would offer to buy the property—cheap. If the deal was done, his company would put out the fire. If it wasn’t, he let it burn. It was a very profitable business.

Land remained the primary investment vehicle until modern times, but the invention of the full-rigged ship allowed another form of investment to develop, in the form of trade with the Americas and the Far East. It could be fabulously profitable. Queen Elizabeth I owned a half-share in Sir Francis Drake’s voyage around the world. It netted her a profit that exceeded all other Crown revenues in 1580, the year Drake returned.

But, as always, risk equaled reward. Many expeditions failed to return at all. The corporation, an invention of the 16th century, and insurance, which developed in the 17th, allowed the risk to be spread more widely, moving trade from a speculative venture to an investment opportunity.

The Industrial Revolution and the development of stock markets in the 18th century opened further opportunities for both speculation and investment. But even in the middle of the 19th century, stock markets remained hazardous places to put your money. The prudent and those with fiduciary responsibilities invested mostly in government bonds, ensuring a steady income and great safety, if little or no growth in capital.

Bumptious, fast-growing, and virtually unregulated, Wall Street was especially hazardous for the unwary and the gullible in the 19th and early 20th centuries. Subject to fearful market crashes roughly every 20 years, it was also subject to wild bouts of speculation and the “madness of crowds.” In 1857, a year that saw a terrible panic, George Francis Train satirized the get-rich-quick atmosphere of early Wall Street:

Monday, I started my land operations;

Tuesday, owed millions by all calculations;

Wednesday, my brownstone palace began;

Thursday, I drove out a spanking new span;

Friday, I gave a magnificent ball;

Saturday, smashed—with just nothing at all.

Speculation and investment in that time, however, were largely the provinces of the rich, and the rich, by definition, are always few in number. Even in the 1920s, probably less than 2 percent of the population owned securities in their own right. But just as good clothes, comfortable housing, and vacations were once exclusively the province of the rich and are now commonplace, speculation and investment are now within the reach of the average man.

Four radical changes since the 1930s have brought that about. First, there has been a vast increase in the wealth of the average family. The GI Bill made it possible for millions of Americans to enter the middle class by acquiring a college education and home ownership. Further, the spread of 401(k)–type retirement accounts put capital in the hands of millions who needed to invest that money. It is a mark of the spread of investable wealth that while stock-market activity was rarely reported on television even 30 years ago, today it is a part of every news broadcast, sometimes when the market is open, with the equivalent of a stock ticker in the corner of the screen. Little wonder that speculation seems rampant.

Second, the amount of research and expert advice available to the ordinary family has greatly increased. In 1940, Charles Merrill reorganized Merrill Lynch and, unlike every other broker in Wall Street, went after the mass market. He trained his men (now called registered reps) thoroughly and opened a research department to look for companies that were undervalued. By 1950, Merrill Lynch was four times the size of the next-largest brokerage house on Wall Street, and its business model was spreading rapidly. The Securities and Exchange Commission began to mandate rigorous training for salesmen. Research departments became commonplace. Mutual funds made it possible for the small account to be professionally managed, aiding those who were not comfortable investing on their own.

Third, in 1975 the fixed commissions—essentially a brokerage price-fixing scheme—that had been a key feature of Wall Street since its earliest days were abolished by order of the SEC. Able to compete by means of price for the first time, discount brokers opened for business and greatly lowered the cost of trading securities. These costs have been falling ever since, with stock-exchange volume, as a result, soaring. Only in 1968 did the NYSE have a daily volume figure higher than the 16 million shares traded on the day of the 1929 crash. Today the New York Stock Exchange trades 16 million shares in the first few seconds after the opening bell.

Finally, the change in the means of speculating has been deeply affected by the technological revolution that is sweeping through all aspects of modern civilization, thanks to the microprocessor. Much trading is now done by computer, in obedience to algorithms devised by programmers and brokers. The results are sometimes ugly, such as the “flash crash” last May, when the Dow Jones briefly dropped more than a 1,000 points in a few seconds thanks to faulty computers.

In 2008 the greatest bull market in history, which saw the Dow Jones Industrial Average go from under a thousand in 1982 to over 14,000 in 2007, came to an end with the bankruptcy of Lehman Brothers. Only swift and decisive government intervention prevented Fannie Mae and Freddy Mac, AIG, Bear Sterns, Merrill Lynch, Citibank, and others from following Lehman down the rat hole of insolvency.

Many speculators were wiped out, as they always are in a market crash. Many crooks, such as Bernard Madoff, were exposed and sent to jail. Wall Street was denounced as a den of thieves, fleecing the honest, hardworking citizenry by enticing them into speculation.

That was the news. What was not news was that millions of American households, while they had seen, at least temporarily, their net worth decline sharply, were still much richer than they had been even 10 years earlier due to prudent investing of the Benjamin Graham kind. Already their portfolios have recovered considerably from the market bottom reached in March 2009.

They won’t all be Warren Buffetts. But they won’t be like the news-dominating and often ruined speculators either, thanks to choosing their place on the risk continuum carefully and investing for value over the long term.

About the Author

John Steele Gordon writes frequently on economic subjects for Commentary and our blog. A revised version of his book Hamilton’s Blessing: The Extraordinary Life and Times of Our National Debt was released recently by Walker and Company.




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