I was waiting for a colleague to join me on a video call last week and decided to see if I had won the Mega Millions. Just as I pulled up the website with the figures, my colleague – one of the business coaches I employ – popped on-screen.
Instinctually, I said, “Hi Nancy! Just a second, I want to see if this call is even necessary as I may have just won $270 million.”
Unfortunately, I didn’t, and we carried on with our call as planned.
It may sound funny that a financial advisor buys lottery tickets from time to time, but hear me out.
When we trade our cash for things, we are either investing or making a purchase, and it is imperative to understand the difference.
For me, buying a lottery ticket every once in a while gives me the chance to dream a little bit of what life would be like if I were to win. At no time do I actually believe I will win – we all know how steep the odds are – but I know for a fact that I won’t win if I don’t buy a ticket.
Sometimes, I’ll put off checking my lottery ticket for months, just to continue to enjoy the prospect that I might actually win some life-changing amount of money. I know that when I check the ticket, that type of joy will end quickly.
Some may call this speculation, but really, I’m buying the tiny possibility of hitting the jackpot and enjoying that time up until I know I lost.
What is Speculation?
Before putting together a solid investment strategy, we have to know what our options are. What should we consider including, and what should we toss aside?
In other words, what defines an investment and what defines speculation.
Speculation is when we put money into something with the hopes that we will earn a substantial return in exchange. Because this relies on hope or conjecture, and not any useful skill or strategy, it comes with a high risk of significant loss.
To me, no one should ever speculate – money is too hard to earn in the first place. That’s why I like to think of my lottery tickets as an expense instead.
That said, all speculation isn’t bad. We can sometimes take a flier, put some money down on black, and hope the roulette gods do us right! It can be fun to do so, as long as our financial plan allows for the amount and timing of our speculations.
So, in short, your speculation must fit into your financial plan. It does NOT, however, fit into your investment strategy.
Your investment strategy is designed to fund your future expenses throughout your life including any legacy goals you have. We should never leave those to speculation.
So, What Defines an Investment?
Here, we are limiting our definition to characteristics of an investment we would consider including in a strategy that funds our lifetime expenses. Something that might increase the possibility we get to do all the things we want in life.
Below are five characteristics that must be included to consider something an investment in this manner.
1. The item in question must be fairly priced. Prices must be set by free-market participants where buyers and sellers decide to transact with each other without outside interference.
If people are freely exchanging their money for the item, then we can say the item is fairly priced. If there are significant periods where no exchanges are being made, then it is not fairly priced. What is the price of something that does not change hands?
In addition, no one must be forced to buy or sell the item. This would distort the pricing, unnaturally, and it’s unlikely we could predict when these forced sales or forced purchases would occur in the future, thus creating unfair prices during those times.
Finally, there must be reasonable substitutes for the item in question. If you are considering buying a share of Netflix but believe it to be too expensive, you might find several other similar (but surely not the same) stocks to purchase instead. This ability to substitute helps drive fair pricing over time.
Never put your money into something that you expect to be unfairly priced. It will not be unfairly priced in your favor.
2. Historical price and trade history must be available. In order to assess anything about how an item acts, we must be able to see how it has behaved in the past. This is necessary, not only to determine value but also to understand something about an item’s future expected return.
This is a significant hurdle for the fancy new strategies that Wall Street gets paid so handsomely to invent. Something with absolutely no price history must have a terrific story attached to it for a slick salesman to have the ability to sell it. The last 30 years are littered with such strategies that never went anywhere (at best) or helped cause market instability in more traditional investments.
Never put your money into something that was invented yesterday or that has hidden price history. You could lose it all – I’ve seen that happen more than once.
3. There must be a “ready market” that allows you to sell, even in stressed times. If there are times when there are absolutely no buyers, it does not qualify as an investment, period.
It’s the market pricing that helps us determine its value. What someone else is willing to pay for it, and why they are willing to pay that amount, tells us a lot about what we should be prepared to pay – or accept as payment when we sell.
Additionally, this tells us quite a bit about what sort of return we can assume over time, especially when combined with how its price behaved during previous periods of time.
Never buy something as an investment that cannot be traded easily. Invariably, when you need to sell, others may sense that fact and be unwilling to pay a “fair” price for what you have. The lack of activity will work against you.
4. It must provide diversification, meaning that it must behave differently from other investments.
If two items behave the same, there is no reason to own both.
Everything you own in your portfolio should bring value to your strategy, either by lowering risk or increasing return. Or, more preferably, both. If it behaves the same as something else, one of the two will disappear, as we will see in the next characteristic.
Never own two items in your portfolio that are precisely the same. It creates confusion, and one of the two is likely not going to pull its weight.
5. It must provide a good return for the risk it brings. There is risk everywhere, but there is also potential return. A sound investment strategy balances risk versus return on an overall basis and within each component.
What type of risk are we talking about? All types. If we have fairly priced markets with historical pricing available, we can feel pretty confident the market is figuring out the risk-reward tradeoff for us. We then only need to understand how any particular component affects our overall risk-reward within our strategy.
Never buy something with a poor risk-reward tradeoff as an investment in your portfolio.
What Gets in the Way?
Considering the above characteristics, lottery tickets, clearly, do not qualify as an investment. For me, they are an expense. (Admittedly, a ridiculous expense when you only consider the math!)
But what about that brokerage account you may use to load up on Facebook, Amazon, Netflix, and Google? Is that an investment?
I argue no, as such concentrated positions actually detract from the overall performance of a well-diversified strategy.
Does that mean you shouldn’t have them? Again, no. It’s certainly ok to have them, just don’t consider them to be a part of your plan for funding future expenses.
How about real estate? Many are hooked on the idea of “passive” income. Ask anyone who has truly been successful putting their money in real estate, and you’ll realize there was nothing passive about it. And that’s in addition to failing many of the rules above.
Owning collectibles, such as guns, stamps, or even jewelry, fall into the same category. Fun as a hobby perhaps, but not reliable to fund a 30+ year retirement, a sabbatical in 10 years, or college 15 years from now.
These and many other items can be non-investments and still provide very high returns. But that is speculation, and we don’t speculate with our family’s welfare.
Here’s the Good News
All of the above points us back to a simpler and more sustainable investment strategy: own the markets. (For more information on this, see our recent post on investment philosophy here.)
Wall Street makes its living by complicating things and selling them to us. Sure, some complexity may be helpful at times, but typically when it comes to your investment strategy, simpler is not only cheaper but absolutely better.
Do you have questions about speculation or investment? Let’s talk! Email me at email@example.com, and we will set something up.