Investing Fundamentals

I really thought I had a good handle on the basics of investing until I heard a speech by Peter Schiff. He has a really great way of speaking about basic investing in a way that really exposes what I think most people take for granted.

His first example was in the stock market. There are two basic ways to make money on a stock, through dividends and through appreciation. There are also basically two different kind of people in the market. Investors look at the price they need to pay for a stock, and then predict how much that stock is likely to pay out in dividends over a period of time, and calculate a rate of return to figure out if the stock is a good deal or not. Speculators don't care so much about dividends, but instead try to predict whether they'll be able to sell the stock to someone else later at a higher price. There's nothing wrong with speculation, but I think a lot of so called investors are truly speculators. I personally always considered myself an investor, but I'm now pretty sure what I was really doing was speculating.

Schiff's actual example was concerning the IPO of a startup during the .com boom. He was approached as an investor in this company. The company was selling the shares at a price that put the value of the company around $20 million (this isn't the right figure, but it doesn't really matter here). The company had no customers, no profits and very few real assets. So why was this company worth $20 million, when someone else could have started exactly the same company for nothing? When faced with this question, they replied that "he didn't understand how the stock market works!" They said that he would make his money because he'd be able to sell his stock to someone else for a higher price. But if the stock wasn't a good deal now, why would someone buy it at a higher price? The answer was that the market was not dominated by investors, but by pure speculators. The problem is that when speculators bid prices up beyond the fundamentals, it can't continue forever. It eventually became so ridiculous that bond holders were making much more money than stock holders were making on dividends, even though stock holders assume a higher risk. Of course, this came crashing back down soon after.

His second example was in housing. If you can rent a nice apartment for a cheaper price than you could own it, then why would you choose to own? The answer from a realtor in the height of the housing bubble was, "You just don't understand how the housing market works! You'll make money because you'll be able to sell it to someone else later for a huge profit." But again, if you can't make any money on a property at today's prices, why in the world would someone buy it from you for an even higher price? The answer again was that the market had become dominated by speculators, and as we now know that didn't last forever.

For me, the issue was that I always thought of speculation as something someone else did. I had several friends who bought houses on little income and assumed that price of their house would always go up. They were speculators just as much as if they had bought gold or paintings or anything else. It's easy to forget that investing is based on fundamentals. In stocks, it's the dividends that you expect it to pay; in real estate, it's the amount of rental income you can earn based on the property. Speculation is a fun game, but I don't think it's one that most of us are truly ready to play.

I highly recommend listening to Schiff's speech as well as searching for his books and writings online. He's one of the few people to accurately predict both the stock market bubble and the housing bubble.