Modern Investing

by David Schneider

  You should not take this option lightly or for granted. Almost all institutional investors, including most professional asset managers, hedge funds, and prop desks, don't have that option; neither do full-time professional gamblers, day traders, and speculators. Professional money managers are paid to manage money, not to sit on piles of cash. Whenever markets rise and keep too much cash, it can seriously hurt their monthly performance. Remember, they are at least measured and judged on monthly performance. Professional hedge fund managers, traders, and prop desk traders are judged on a daily basis, so the pressure to perform is enormous. If you have chosen to become a full-time trader, you might have realized that all of those monthly subscriptions, data feeds, and memberships cost money. You are forced to meet your monthly obligations. Sitting on cash doesn’t help.

  Controlling our cash and cash inflows is the advantage that even the “little guy” has. Certainly, this option of keeping cash is not free and comes at a price. The foremost of these prices is the possibility of missing out and losing money.

  In my opinion, the cost is negligible. This is why: We know from the phenomenon of the gambler's ruin, the tendency for gamblers to overbet and to panic on a regular basis. Mistakes are bound to happen in the money game. Big mistakes! It’s a mathematical certainty. This offers a sure and never-ending stream of opportunities for those who can wait and have the financial resources ready. Treasure your first and most critical edge, then take advantage of it.

  Finding Opportunities

  Next is a matter of finding opportunities. There are two simple approaches:

  You always search for ideas and mispriced bets in all markets and financial assets.

  You wait until the markets offer you opportunities within your existing area of expertise.

  Both are valid strategies and have their place among established and experienced investors. Many investors combine them. Full-time investors and hardened entrepreneurs favor the first approach. However, it is extremely time-consuming and requires a distinctive work ethic that can be described as “obsessive.” The effort does pay off because a few talented and experienced investors find appropriate investment opportunities in almost all market conditions. This approach has one structural weakness: the practitioners themselves, their tendency to overestimate, and their skills at finding opportunities. They come up with all sorts of flawed reasoning to justify their activity and salaries, hence taking unnecessary risks.

  I don’t recommend this approach to the average investor, especially those who operate businesses or have everyday jobs. There is simply not enough time to show the level of dedication and commitment that this approach would require.

  The second approach is much less work-intensive. You can focus on your primary cash flows—job or businesses—where you have a competitive edge and enjoy an information advantage. Only occasionally should you venture out and consider investments in either private or public markets. Of course, this only works if an investor:

  Knows in advance what he wants to invest in.

  Obtains a purchase price that makes economic sense, and provides plenty of safety and promises an adequate or even superior return.

  Because these types of bets are rare by nature, and very different with each player, we can reject most proposals by default, especially those offered by countless third parties who have totally opposing incentives. On the other hand, if we come upon one opportunity that fulfills the criteria above, we can commit money and accept the remaining risk. After all, that is the primary job of an investor: to take risks.

  So, start building your area of expertise. Anybody can do it. It’s risk-free, and age is no limitation.

  One Decision at a time

  This chapter only scratched the surface of a much wider and more complex topic for developing an individualized investment strategy. I would suggest studying each topic in greater detail: stock selection, strategy, and product categories. I have published a book on investment strategy and philosophy titled The 80/20 Investor, which is the logical sequel to this book. Also in the appendix, you will find an overview of the most relevant money games and their players. The next book in my series is a critical discussion of index funds, which are now all the rage and widely promoted. In the context of this book, I will demonstrate that index funds are just another way to keep “gullible” players in the market; and that for them, there might be some very unpleasant surprises in the making. If you have a financial interest in index funds or are considering investing and don’t like surprises, this book is for you. Please register and subscribe to NomadicInvestor.com for updates on upcoming book projects.

  Final Test

  Here is the final test to make sure you have understood the few principles of investing and base strategy. Let's say you have $50,000 in cash and it grows with every passing month. Nervous to miss out, and eager to let your money work for you, you ask a close friend, a licensed financial advisor, and your local banker for advice. Your friend recommends a strange sounding company that has something to do with VR and AI technology, something that is popular on social media and among techies. Your banker and advisor recommend a mix of different mutual funds and ETF’s that look very much alike. The banker might recommend more international stocks and your advisor higher yielding corporate bond ETFs for your mix. Tell me, what are YOUR odds of success for each recommendation? What is YOUR personal edge in any of these recommendations? If you can't answer these questions, you should remember an old poker proverb: “If after ten minutes at the poker table you do not know who the patsy is—you're the patsy.”

  AFTERWORD

  “When the sophisticates are Accumulating, they have to be Accumulating from someone, and when they are Distributing, somebody has to be there to buy.”

  – George Goodman

  So much of what passes for investing today is, as we’ve seen, gambling and, we have made it respectable. It is a result of the incentive and legal structure that continues to exist on Wall Street, and that provides us with new and elaborate forms of gambles. Unfortunately, it comes with all the side effects that a traditional gambling environment attracts: cheating, fraud, and continuous streams of con tricks and Ponzi schemes. But what tops it all are the neverending losses, especially among masses of retail investors.

  Wall Street counts on the gullibility of its players, and they don't disappoint. Modern capitalism seems to be powered by it. If the sacrifice is the savings and capital of masses of naive investors, so be it. As a result, there will be another massive wealth transfer to the few players who know how to play the games.

  These days, the official trend is that investment banks reduce their trading operations or spin them into separate and independent legal entities and their potent hedge funds in disguise. Regardless of the regulations that continue to be imposed on investment banks, their trading operations, and their cronies will continue to survive. With the treasure chest of information they possess, easy profits and risk distribution patterns are too juicy just to give up. Their existence will reveal themselves again, when we experience another financial crisis and the finger pointing reemerges.

  Even though individuals are usually responsible for any illegal actions within Wall Street institutions, it demonstrates the predominant culture. Top management at banks, of even the most reputable firms, have a “Don’t ask, don’t tell policy.” They give conflicting signals to their troops. On one hand, they officially emphasize and enforce strict compliance rules. On the other hand, they put pressure on key personnel to come up with performance numbers to satisfy their shareholders and, more importantly, their bonus payments. A branch of Wall Street is dedicated to legally circumventing regulation in the most creative and elaborate way. When that doesn’t work, the rules are bent and changed in their favor. One side effect is that a few more shady figures, don’t hesitate from abusing their privileges and power positions, in manipulating even the most significant and public economic references rates to their financial advantage. This often means che
ating on their competition and most valuable clients.

  On the other hand, many bankers and investment professionals are ethical, hard-working, and fair to their clients. But on Wall Street, a small minority is all it takes to operate giant Ponzi schemes or bring an entire system to its knees. It took one man, Nick Leeson, to single-handedly bring down Barings Bank. It was Bernie Madoff who wiped out $18 billion of his client’s assets– clients he gleefully called “gullible.” On Wall Street, it only takes one person to have maximum impact.

  In effect, we are all a part of a massive gamble– a big bet taken by society as a whole. We are all gamblers because we put our faith and trust in a system that is controlled and managed by gamblers who don’t play by the rules, have their own financial agenda, and consistently overplay their hands. As we now know, society’s bet on a bunch of gamblers could go either way. Whatever the outcome of this once-in-a-lifetime gamble, it is a colossal risk that won’t have many winners.

  Make Haste Slowly

  The primary purpose of this book is not to pillory anybody or show that the current system is flawed, inherently corrupt, and rigged. We already know that. This book is about drawing the right conclusions for yourself and your financial well-being.

  No investment will ever be without risk of losing money, not even the most sophisticated diversification model, revolutionary crypto currency or hedging techniques will change that. You don't avoid risk after you commit money, hoping that diversification or hedging will miraculously protect you from mistakes, ignorance, and losses. You avoid unnecessary risks before you make a decision.

  There are valid arguments that suggest staying away from the money game altogether, and focusing only on the areas that you can invest easily in and directly control. It might be your greatest edge over Wall Street and professional players, one that even the little guy enjoys. There are also good arguments for taking a more passive role towards investing in general: you can let the market come to you rather than chase it. Always remember, you are not an institutional money manager, nor are you competing with benchmarks or other investors. Your job is not to beat indices on a weekly, monthly or yearly basis. Your single most important job is to secure your wealth, by not filling the pockets of the fat cats and other professional gamblers. Only through serious contemplation and acknowledgment of your psyche can you gain a satisfactory answer. To play or not to play? That is the question.

  If I made you uncomfortable, aware, critical towards playing the money game, towards putting your money with Wall Street, and following conventional practice, then I have achieved my goal.

  If you have realized that you are being manipulated, that you are being pushed into lousy bets for the sake of utilizing your “dormant’ cash” so that others can profit from it, I have saved you a lot of money and possibly some psychological pain.

  If you have realized that real wealth creation and above average returns are possible through personal investments, business ownership and taking a few, high-probability bets where you enjoy a particular edge and understand the underlying assets, you will have begun to lay down the foundation towards your financial independence and future wealth.

  Similar to what Adam Smith envisioned for his utopian society of rational individuals with moral standards, the moderate self-interest of each can grow the economic pie for society as a whole. So study the games, practice your skills, and start investing on your terms!

  APPENDIX I

  THE GAMES

  Like in a casino, financial markets offer different types of games that meet a player's individual taste. Some games appeal to the masses like slot machines, and then there are games for pros with secret VIP rooms for high stakes games behind closed doors. They exist in financial markets as well. There has been a constant flow of new games. The brightest and most motivated people working on Wall Street, (with degrees in physics, mathematics, or engineering), are dreaming up new games as we speak.

  In this section, I will only mention the most popular and well-established games, but the different variations are numerous and still growing.

  Demand Adequate Returns

  Before you start reading about the games, I would like you to spend a moment on the issue of selecting the right investment and games to play. It comes back to the option of cash: our most critical edge. At times, it might be difficult to have the exact parameters to choose the right investment. From my experience, the best and simplest filter for selecting winning investments and avoiding unnecessary risks is demanding adequate returns right from the start. Conventional textbook advice is that investors should aim for the following rule of thumb: the higher the perceived or calculated mathematical risk, the higher the returns should be. Tiny yields are okay, as long as the perceived risk is also minuscule. Though this is a fantastic solution for sellers of financial products because they offer abysmally low returns with generous fees, it is a far too simple guide for the world of real investment returns, unexpected events, and real losses.

  Individual investors should always demand appropriate returns for any investment. Ten-year government bonds yielding negative rates or corporate bonds yielding 2% or less just don't fit the bill, even though they are considered safe in a conventional sense. Same thing with index funds that seem to promise 6% (and most likely much lower yields going forward), but don’t even give you the promise to return your capital in full, as bonds do. Proponents of this approach, who emphasize the long-term nature of these investors, ignore the aspect of fraud, the consequences of a flawed financial system, and putting too much faith on past selective statistics.

  Adequate returns might be difficult to pinpoint and might differ from investor to investor, but if we consider real business returns (returns on invested capital of the underlying assets) from various industries and historical return figures of leading investors, we can develop a sense of adequate return expectations.

  From Graham’s partnership records to Buffett’s investment track record, we can see a return profile ranging from 10% to 20% over very extended periods of time; investing foremost in other businesses and financial market instruments without the use of excessive financial leverage. This is a return range that can be considered adequate for any conventional investment risk. If your return requirements are not met, you should keep a diversified portfolio of liquid assets, rather than commit long-term to abysmal performances and unknown risks. Remember, there are always plenty of investment opportunities in the world outside of the money game.

  CASH—THE BASE GAME

  It all starts with a simple cash flow that we can control and accumulate over time.

  Without a cash flow, there won’t be capital to invest. Without a constant stream of cash, we might not have the flexibility and financial perseverance to maintain a prudent investment strategy. Without continuous a cash flow, even the wealthiest investors might be forced to liquidate potentially profitable investments at the worst possible moment. Hence, if retired people think they need to gamble some of their remaining funds in financial markets, they better make sure they have a stable cash flow of existing investments or a decent part-time job. Otherwise, they might be up for some rude awakening similar to the financial crisis we saw in 2008.

  So how do you establish your primary and constant cash flow? We all have one asset given from birth: time. Time can be converted into money, and it functions as a currency in life. How do you turn time into hard cash? Through work and saving, before you spend any of it. There is no easier way to convert time to cash than using our natural affinity and capacity for work. Hence, it makes sense that the first and most important investment in our life is in ourselves, through education and training.

  The cash game works, and there are countless examples of individual investors with average-paying occupations or small to mid-size businesses who were able to lay the foundations of their financial freedom, even in less economically developed countries.

  Yet, with all its benefits, there are two problems with this game. First,
it's incredibly boring, especially for generations with short attention spans. And nowadays, it doesn’t pay interest anymore. In a zero interest environment, the cash game has lost all of its remaining charms.

  The other issue is that, according to financial experts and institutions, cash is “extremely dangerous” for your well-being and economic future, especially for your retirement. Apparently, the fear of inflation is so large and concern about retirement so burning hot, that they can’t help but warn everybody of cash’s evil nature. The message is clear: “You have to be in the markets.”

  Whatever Wall Street or their network of salespeople tell you, cash should always be the preferred, default asset of choice. Be absolutely clear: if you can't play this basic game, you shouldn't be playing any other games. If you can’t earn, you have no business investing.

  GOLD IN YOUR PORTFOLIO?

  Gold is an excellent asset class that I love and wish that I had more. Technically, gold cannot be classified as an investment. Rather, it is real money that can be converted into any paper currency. It is an asset class without direct economic value creation unless you use it for industrial production or put it in your mouth as a tooth replacement. It induces high fees for brokers. Besides, you can’t just walk into a convenience store, buy a Snickers chocolate bar, and pay with a bar of gold. Most of the time, if we store it somewhere securely, it costs us a substantial yearly fee to maintain the vaults and its safety/security procedures. I sometimes joke with my friends who are obsessed with it. Imagine you lay down two bars of gold, cleaned and polished, in a spacious vault where it’s dark and comfy. You close the vault doors and leave it dormant for at least a year. After a year, you open the vault and outcome the same two bars of gold but with little tiny gold coins. Wouldn’t that be fantastic? Unfortunately, that is just a dream.