Investment 101 – Say “NO” to Crypto and The Difference Between Trading and Investing

It’s kind of funny sometimes to straddle the worlds of spirituality and finance. So many of my spiritual friends want to invest their money well, but they were never given an education about the basic principles of investment. I have read so many articles saying that “crypto is good because it opens up investment to people who never had an opportunity to participate in the market.” But this is utter nonsense. Crypto and meme stocks and the market around them are encouraging well meaning people to take huge risks with important assets. I know a lot of good people who have real money tied up in completely specious assets like crypto currency and meme stocks. Some of them may end up exiting their positions with a trading profit if they exit their positions at a market peak, but this does not mean that they are acting as investors. They are acting as traders, and there is a huge difference!

The difference between trading and investing.

Trading and investing are two completely different concepts. Trading is the practice of buying something and then trading it for something of higher value later. Baseball cards are a great example. If you have a deck of baseball cards, you can trade them with your friends. You can either trade them directly, my Hank Aaron for your Derek Jeter, or you can buy them and sell them. And baseball cards might even hold their value for quite a long time, so long as there are a lot of people out there who still want baseball cards.

Compare this to buying a share of a company like Apple, which the favorite stock of my favorite investor, Warren Buffett. When Warren Buffett buys Apple stock, he well knows that there may come a point in time where there is someone who wants to pay him a lot more for his shares than he thinks they are worth, and in that case, he might sell them. But that’s not why he bought them in the first place. He buys the shares because he wants to own a portion of the income stream produced by Apple’s business. He is buying the stream of income generated by Apple’s business. This is an investment in the underlying business of Apple.

Baseball cards, like crypto currency, do not actually produce anything at all. They may become more scarce as time goes by and copies of desirable cards are lost or destroyed, or locked away in collections that are out of circulation. This may cause the price of these objects to increase, but it’s not quite the same as producing anything of value. In actual fact, they only produce expenses and losses. If you have a big collection of items like cards, or stamps, or vinyl records, you have to take care of them. You will have expenses and occasional losses. But one thing you will never have is a revenue stream.

Investors make money even if they never sell

The key understanding about investing in stocks is that you are actually purchasing a portion of the underlying company’s revenue stream.. If you invest money in a business with underlying profit, you will participate in the earnings of the company, and you will make money even if you never sell. This gets a little confusing in today’s world because investors are highly motivated to avoid taxes, so companies are always looking for how they can return profits to investors while minimizing taxes. There are four essential ways for companies to return profits to investors.

Four Ways Companies Return Profits to Investors

The first way for a Company to use profits is for the company to invest the profits in assets for its own operations. They may use it to open a new factory or develop a new product line or even to make an acquisition of another company. If they do so, then the profits, which would be collected in the form of cash, are converted to long term assets of the company. This practice of reinvesting profits is very common in growth companies, and in this way profits will increase the value of each share of the company, because now each share is a small part of a larger company.

The next way to use profits would be to pay off some company debt by retiring some bonds or by paying off a loan. In this scenario, the “short term” asset of cash reduces the liabilities of the company. The profits came in to the company as cash and then flowed to decrease liabilities instead of to increase another asset. This will have the same effect on the value of each share as an asset purchase.

Third, they might decide to go into the stock market and buy back some outstanding shares of their own stock, if they believe it is trading below fair value. Berkshire Hathaway has been doing exactly this over the last couple of years. And if you really want a smart investing tip, simply do what Warren Buffett does. If Warren Buffett is buying shares of Berkshire Hathaway, and you have money to invest in the stock market, you might want to think about buying some Berkshire Hathaway shares yourself. When companies buy their own stock, they reduce the number of outstanding shares, and that changes the math a little bit, so every remaining outstanding share owns a slightly larger percentage of the company.

The last thing the board might decide to do is distribute the cash it earned to the shareholders in the form of a dividend. Most mature companies do pay a dividend. This directly profits each shareholder.

The first three of these strategies result in unrealized capital gain for the investors. The intrinsic value of their stocks have increased because the company balance sheet has improved. These profits are not taxable to the investor until they sell their shares. When a company pays dividends on the other hand, the money received is taxable to the investor. Until recently there was a penalty in the tax system for dividends, because they were taxed as ordinary income. As a result, companies would often have an incentive to buy back shares instead of paying dividends.

False Capital Gain from Trading Momentum

The real gains from companies that earn profits outlined above are very different from the unrealized gains many traders see in their personal stock or crypto accounts. When traders purchase stocks with the intent of selling them in the future at a profit, they are not so concerned with the earning of the company during their ownership period as they are with the price some future purchaser might be willing to pay. The more, the faster, the better. This is known as momentum, and investing in momentum never ends well.

If you want to do some research, you can start with the Dutch Tulip Bulb mania of 1534, dramatic rise, crash of the South Sea Company in the year 1711 in London, the tech stock bubble of 1999 to 2000, or the leveraged residential real estate bubble of 2007. There have been many changes in Human circumstances but not much improvement in the madness of crowds.

Crypto Currency Has No Intrinsic Value

It is important to understand the difference between the market value and the intrinsic value of an investment. Crypto currency and Meme stocks have market value. There is no doubt about this. You can go and buy or sell 10 bitcoins for about $39,000 each, and net a cool $390,000. If you only paid $3,000 for them, well then you just put $360,000 in your pocket. But the only reason a bitcoin has value is because someone is willing to pay for it. Bitcoins do not actually produce anything. On the contrary, they require huge resources just for a computer network to “remember” that they exist and who owns them. A company’s shares have market value as well, but underneath the market value is a going concern that actually makes things. The intrinsic value of a share is what an investor should expect to receive in future profits over the remaining expected life of the company.

To illustrate this, imagine what would happen if a large number of bitcoin holders decided to take their profit out of bitcoin at once. There would be a game of musical chairs as people tried to liquidate their holdings into a vacuum of buyers. The first sellers would satisfy the highest price orders, and then the price offered by the next willing buyer would be lower, and so on. The “market value,” which is simply the number of bitcoins multiplied by the last sale price, would rapidly head for zero. In the end, all that would be left would be a bunch of idle computer servers with no cash flow to keep the power on, and bitcoin would just be gone. There is no intrinsic value left for the small group who end up owning all the bitcoins.

Compare this to a hypothetical crash of Apple stock. Imagine if everyone wanted to sell their shares of Apple at the same time. The last buyers, who would undoubtedly include Warren Buffett, would then own a giant company with amazing Human capital and technology and plants all over the world that makes a staggering number of devices each year. There might be a musical chairs for the shares, with everyone trying to get out at once, and the market value might crash, but this would not in any way change the essential value of Apple as a going concern. At the end of the market route in the share price, the remaining stock holders would own a great company and billions of dollars in cash flow. Apple has intrinsic value, bitcoin does not.

Meme stocks are similarly detached from intrinsic value

A meme stock is one step up the food chain from crypto, because at least there is some enterprise behind it. However, the shares are traded like baseball cards as well, because the prices they trade at have no connection to the underlying business’s performance. Let’s look at GameStop for an example. I cannot think of anything to explain why someone would think a brick and mortar store to sell video games is a good idea. I was driving down south Dixie Highway in Miami today and saw that the old Specs Records and Tapes building was torn down for a new project, and so went the days of the brick and mortar store for selling music. Remember Blockbuster? I have not heard any explanation for why GameStop is a winning business model. But sometimes people are motivated by other forces such as nostalgia. I would imagine that many millennial aged men spent a lot of their free cash at GameStop when they were young, and so now they remember the store fondly, and they were therefore inclined to buy the stock.

Tesla is a good company with a very expensive stock

Tesla stock is another interesting example because it actually has a very good business and a credible story for why it will continue to grow into the future, but its stock price is extremely high relative to the expected earnings of the company. So the analysis with Tesla is more nuanced. I love the company personally, but I do not own the stock because I believe it is considerably overvalued. Elon Musk himself has specifically acknowledged that the share price is high, and he has also sold, and caused Tesla to sell, a huge number of shares since Tesla tock price started its most recent surge. On the other hand, Tesla is revolutionizing the entire transportation industry. Also, I drive a Tesla, and I believe in owning stock in the companies I do business with.

But Tesla stock is currently down roughly 1/3 from its all time high and it is still trading at 276 times its earnings. This means that it would take 276 years for the company to earn its own value at the current rate of earnings. That’s a long time to wait to get your money back, especially with inflation now running above 5%. Tesla is definitely a growth stock, and who knows, maybe they go parabolic in their business. I would celebrate that. But Apple posted record earnings as well, and it only takes them 28 years to earn back their own market value. Berkshire Hathaway stock is selling at under 9 times earnings. So if you invest $1,000 in each of these shares, it would take 276 years for you to earn $1,000 from Tesla, 28 years to earn it back in Apple, and 9 years to earn it back with Berkshire Hathaway. We can all talk a lot about the future, but in ten years, shares of Berkshire Hathaway will have earned their own value back. It takes a very compelling story about the future to make me want to wait another 266 years.

What do you do now?

If you are trading stocks and crypto for fun with money you can afford to lose, then enjoy your hobby. But remember this kind of trading is a zero sum game. For every winner there is a loser of the same amount. If you have real money that you need for your future invested in crypto, you might come out ok. Maybe this time really will be different. But you might also lose your entire investment. My preference is to invest where I believe the intrinsic value of the company is higher than the current stock price. I may not make the most return, but I sleep soundly. If I inherited an account full of crypto and meme stocks tomorrow, I would immediately sell all of it and invest it in good profitable companies with reasonable share prices.

Wealth – Tips for new investors for 2022 that your financial advisor won’t tell you.

I have helped a few people in their early thirties start their savings and investment programs since the start of COVID, and there are some pretty simple principles that make a big difference in getting the results you want. If you follow these basic ideas, then you will be off to a good start.

Surprisingly, many of these basic truths are completely contrary to the advise given by the financial services industry, from banks to financial advisors. Remember that all large financial institutions exist for one purpose only, and that is to maximize the profits that flow to Wall Street. They give us terrible advice, and they encourage us to use a lot of debt, insurance, and investment products that can be ridiculously expensive and even financially ruinous. My favorite resource for investing advice is Warren Buffett. He makes it very very clear that we should stay away from debt and from financial services fees. I encourage every new investor to read Warren Buffett’s annual remarks from the Berkshire Hathaway shareholders meetings, and pretty much anything else he has written.

The first question people ask me about investing is how much they should invest. It helps to remember that you invest your wealth, and wealth is what you have beyond what you require to meet your basic needs. You don’t invest your rent money, or the money you are saving to buy a car in six months. Instead, you invest money that you have or earn that is in excess of what you will need in the next couple of years. If you were to simply leave this money in your money market account, inflation, which is currently running at well over 5% per year, will erode your money’s purchasing power. You would not store your grandmothers silver in an acid bath, and so you should not store your long term savings in accounts that earn less than inflation.

To figure out how much to invest, you need a basic understanding of your financial position. There are two basic concepts here. The first is your balance sheet and the second is your income statement. Your balance sheet is a picture of your net worth at a particular moment in time. Usually it is formatted as two lists. The list on top shows your assets and the one on the bottom shows debts. The balance sheet shows your current financial inventory. At the time of this writing, December 31 offers a great point in time to assemble your balance sheet. Simply write down the balances of all of your accounts, and then estimate the values of your fixed and marketable assets like your car and your house. Do not count things you could not easily sell. Everyone should have a basic understanding their balance sheet before they can make decisions about how much to invest.

The second is your income statement, which you can also call your budget. While your balance sheet is like a photo of a moment in time, your income statement is like video of your month. How much do you earn each month, and how much do you pay out. Your income statement shows all of your sources of income on the top, and all of your expenditures on the bottom. If you have more income than you have expenses, then you generate a little wealth each month. If you have more expenses than income, then you must give up a little wealth each month.

There is a very important concept hiding in here, which is the relationship between your income statement, or budget, and your balance sheet. At the end of each month, you can either deposit the excess into your investment account, or you must make a withdrawal if you are short. So if your budget has a deficit over the course of a month, at the end of the month, you would have to either withdraw money from a savings account, or add to your credit card balance to “make ends meet.” Making ends meet is the challenge faced by so many working families that simply have more expense than income.

A good rule of thumb is that you should only invest money that you will not need for at least two years. So, if you have a balance of say $25,000 saved up, and your deficit is $500 per month, then you will need $12,000 in cash to get to through two years. That $12,000 you need to tuck away somewhere safe where it is readily available to you. The remaining $13,000 you can invest.

Here is the first place you can work in 2022 to really improve your financial position. f you can work on your budget a little bit so that you have a little bit more each month than you started with, it makes a huge difference in your financial position. If you can convert a $500 monthly deficit to $100 surplus, then you can invest a larger portion of your money to start, and you can add to it each month from your surplus.

Let’s compare the two situations where we start out 2022 with $25,000. In the first example, we run a $500 monthly deficit, and in the second a $100 monthly surplus. In the first example, you put $13,000 into the market to start, and at the end of two years, your investment portfolio will be worth $15,730 if you assume a ten percent return. Over the course of the two years, you would have spent the remaining $12,000 to make your budget work. In the second case, you would be able to make an initial investment of $25,000 that would be worth $30,250 at the end of two years, and you would add $2,400 plus the returns on those additions. Close to $35,000 total wealth at the end of two years.

You can see that the monthly deficit will cause you to completely deplete your savings within 5 years, while the slight surplus is quickly moving you toward financial independence. And this is the most important topic. Financial independence. Financial independence comes when you have the freedom to live your life according to your values without financial considerations determining your life. It means you have your life in order so that if you want to accept an invitation to spend three months in Costa Rica, you can do it. Living simply is the fastest way to financial independence.

Let’s sum this up here. The first question is how much should I invest, and that answer is you can start by investing any cash you don’t need for two years, and you can add to this your monthly budget surplus.

The second question is how to invest it. And the first answer is always pay off your high interest credit cards. Anything that charges you more than 10% interest a year is horrifically parasitic. You cannot rely on earning 10% from the stock market every year, but you can certainly guaranty that you are going to have to make those interest payments. The good news is you have a 100% chance of not having to pay interest on debt you pay off, so the impact of paying your credit cards is huge. Let’s go back to our example…

If you have $25,000 in savings, currently earning zero, and $25,000 in credit debt where you pay 18%, and you adjust your budget to have a $100 per month surplus instead of a $500 deficit, then your financial position will improve dramatically. Just the act of paying off the credit card with your balance will net you almost $10,000 in two years. Paying off your high interest debts is your first investment.

Now let’s move on to purchasing investments. We have determined how much we have to invest, and we have worked on our budget so we have at least a little surplus every month, and we have paid off our high interest credit cards. Now what?

Now it’s time, quite simply, to head to the stock market. This is where our old master teacher Warren Buffett really offers the best advice–invest your money without paying fees. Financial advisors hate this advise, because they all make their incomes by charging what are known in the industry as “wrap” fees. In other words, they convince you to deposit all of your assets with them, and then they take a seemingly insignificant little fee of 1 or 2%. Just pennies right? WRONG! These fees eat your savings alive. Let’s say you have a financial advisor who charges you 1.5% on everything you place with them, and then they put you in ETFs or other funds that charge another fee. By the time you get to the bottom of all the hidden fees, you could be paying 2% or 3%!

What does this not sound like so much? Think of this. A long standing rule of thumb is that you can withdraw 3% from your account each year and expect to earn enough on top of that to cover inflation and maintain your standard of living for the long run. If you retire at 65 years old with $1,000,000 in the bank, that means you can withdraw $30,000 per year. That’s it.

But wait… you are paying all of that to your financial advisor! Even if your total fees are only 1%, which is what institutional and ultra high net worth investors pay, that’s a full 1/3 of what you can withdraw each year. Warren Buffett talks about this all the time. You have to compare the fees to what you can withdraw, and you will see that 1% is really 33%, and 3% is really 100%.

What makes this worse is most financial advisors have been stripped of any real ability to help you pick investments. They used to help us pick individual stocks that we would buy and hold. We only had to pay fees in those days, like back in the 1980s say, when we bought or sold stocks. But now, all of the firms use wrap fees and let you trade for free. What financial advisors do now days is create an “asset allocation.” This is where they make a pretty pie chart and invest in different asset classes. You will have a slice of international equity, a slice of domestic large cap, a slice of fixed income, either muni bonds or taxable bonds, and so on. All of these slices come in the form of different funds that all have hidden fees inside them.

Since the early 1990s when the industry really started moving in that direction, the primary method of allocating assets was to first determine an investor’s risk profile. In this methodology, a young person with more income than expenses would be able to take higher risk, and a retired person with fixed income would be lower risk. High risk profiles might be 80% stock and 20% bonds, and low risk investors would be 80% bonds and 20% stocks. And within that risk profile they divide up the pie into different segments. Is that familiar?

But there is a huge problem with this now days, and that’s that bonds are simply not at all a viable investment. They simply do not qualify as an investment at all because they are guaranteed to pay you a return lower than the rate of inflation. (And for those who are going to suggest Treasury inflation protected securities or TIPS, they are selling above face value today, and so they offer no solution) The bond market is a little confusing, because of the math around bonds. Maybe that’s a topic for another blog post, because it could take several pages. But the bottom line is this, when interest rates are near zero, as they are today, then bonds trade at prices close to their face value, which is the principle amount of the bond that is returned to the investor at the end of the bond’s term. That means you could sell the bond today for the same amount it will be worth at maturity PLUS all of the interest payments. In other words, there is simply no reason to wait to collect the money. If you buy a bond today, the sum of all the payments you will receive is no more than you paid, and in the meantime, inflation errodes the purchasing power of the money when you do get it back. This is a terrible deal.

Most financial advisors cannot wrap their heads around this. They they have been so baked in the mold of the 60/40 stock to bond portfolio, that they simply cannot see that the bond part of that equation makes no sense anymore. It just does not.

The only place to put your money right now is the stock market. Period. This is because stocks have earnings and pay dividends and that can increase in value with inflation. Bonds have a fixed face value. A good way to think of this is that stocks have value in real dollars while bonds have value only in nominal dollars. Think of inflation as salt water. Bonds rust in salt water, stocks don’t. It’s that simple. If you have a 6% rate of inflation and 1% in fees, then a bond needs to pay 7% before you even break even. Stocks can go up with inflation.

All this talk of Robinhood and the Meme investor that we read about in the news anymore actually does make some sense. People are fed up with the industry and they want to take control, avoid fees, and make their own trades. There are many many platforms available for this. I refer most people to Schwab to set up their own investment account.

So where do most Meme investors go wrong? They trade stocks like baseball cards, and focus on the market prices of the stocks. This has caused popular stocks to become completely detached from their underlying “boring” fundamentals. Take Tesla as an example. I love the company, I drive the car, I admire that they created the EV revolution, and I think it’s amazing that Elon Musk is devoting his wealth to sending humans to Mars. But the stock? It is currently earning about $3.06 per share each year, and each share costs $1,070. When you divide this up you get a “Price to Earnings ratio” of about 345. Which means the stock value is 345 times annual earnings. I find that people have a very hard time feeling what this means in their bones. PE ratios are easy to glaze over.

I like to think of it like this. How much stock do you need to buy to get a $1 of earning? If you want to buy enough stock to earn $1 a year in Tesla, it will cost you $345. That’s why I own a Telsa, but zero shares of Tesla stock. Let’s compare this to boring old PNC Financial Services, one of my favorite stocks, maybe our largest single position other than Apple. PNC is trading at about $200 per share with earnings of $10.17 per share. The PE ratio is 19.71. Which means you have to pay $19.71 to get $1 in earnings per year. Next look at Verizon, which has been beaten up over the last year. Verizon trades at about $52 per share and earns $5.32 per share each year. The PE ratio is 9.77, which also means that to secure $1 in earnings power, you would have to invest $5.32.

Does that amaze you? You have to buy $345 worth of Tesla to get $1 worth of earning, and you only have to invest $5.32 in Verizon to earn the same amount. Moreover, each share of Verizon actually pays a cash dividend of almost $2.56 per year per share, and a share of PNC pays $5.00 per year. Tesla pays zero dividend.

When you invest in the stock market, you are investing in earnings of a company. We have Social, Environmental, and Governance (“ESG”) requirements in our investments that we use to choose companies to invest in, but when we make the investment, it’s in earnings. We personally choose not to invest in alcohol, weapons and defense, agricultural chemical producers, oil and gas companies, casinos, private prisons, or tech firms that market consumer personal information like Meta and Google. We avoid investing in harmful and parasitic ventures. The only exception is that we invest in Berkshire Hathaway even though they have some oil and gas holdings.

When you pick your stocks, first run this ESG screen so you can be socially responsible. Then invest in stocks that you can buy and hold and profit from the earnings of the underlying company.

What about all the high flying Meme stocks? What about earning 100% in a month on GameStop? Someone will eventually going to be left holding the bag when the selling starts. If you have stock in a company with no earnings, the only way to get your money back is to sell the stock to someone else. The only way to make money is to find a bigger fool. With the federal government literally sending fools checks in the mail, the odds of finding Meme buyers are pretty good…until they aren’t.

Bitcoin is a good example. I don’t know if Bitcoin will hit $100,000 or $1,000,000 or if someone will create a quantum computer that cracks the code and makes the whole bitcoin system fall apart over night. What I do know is that you cannot walk into target an buy things in bitcoins, you have to convert them to dollars first, and that means you have to find someone to buy them. And they don’t actually produce or earn anything. To the contrary, they require huge resources to power the computers that check the transactions, and these costs are paid with more bitcoins. The entire thing is a giant Ponzi scheme.

Suppose the entire stock market blows up and you can never trade another stock. If you own companies with earnings, they will eventually earn your money back for you in real dollars. If you have baseball cards, they will not earn anything. They are only valuable if someone else wants to buy them.

And that’s it in a nutshell. The first step is to find out how much you have to invest. Then open a low cost account, and then invest in good companies that have earnings. If you do this, you will not pay any fees and you will have solid long term investment results. Good luck and please let me know how you are doing.