I. Investing, Rightly Understood

Key take-aways

  1. Investing is providing money to a company or other entity in order to allow it to develop the capabilities to provide a product or service of value to people, its customers.
  2. We do this in order to gain a financial return, and the basis for this return must be the profit streams or cash flows that the business or entity will generate from selling its product or service.
  3. Investing requires a reasonably long time-frame, as opposed to short-term trading.
  4. In assessing future cash flow streams, investing requires reasoned analysis, supported by a historical track record. Without these, we are speculating.
  5. The funds forming the core of your investment plan should hold stocks and bonds that each meet all these investment criteria.

Before you try any activity, certainly one of consequence, it helps to have a clear idea of what you’re actually setting out to do.  Unfortunately, your notions of what constitutes investing may very well be muddled or off-base in the first place.  Because people throw around loosely the word invest and its derivatives, investing, investment, investor.  Activities that are labeled—especially in financial media—as investing often do violence to the word.

On the home page of the Learn tab, I provided a dictionary definition of investing: to provide money for an enterprise, such as a corporation, in order to gain a financial return.  Here we dig into this definition more deeply, identifying the essential attributes of investing.

Why an Enterprise Needs our Investment

To begin, you are providing money to some enterprise, which is to say to some entity that is undertaking to do something.  The definition we cite uses a corporation as an example, and we would agree that some kind of company undertaking some kind of business is the best example.  The business requires money up-front to build or buy some plant or develop some kind of capability in order to offer a product or service of value to customers.  The revenue from those customers is the basis for the financial returns that follow.  The enterprise could also be a government undertaking a specific project like a highway system or generally advancing the goals of its citizens (in an ideal world), whereby tolls or future taxes are the basis for the financial return.

Note that your investment could take the form of debt (loan or bond) or equity (stock).  With debt, you have the right to be repaid with interest; with equity, you get the benefits of ownership, including participating financially in the fruits of success.  A key difference between the two forms are the terms of the return, including how well-defined the return is.

We Invest for the Return

Financial return is the key concept in our understanding of investing.  Very simply, you put money in up front in order to get more money back in the future.  You can get your money back in three ways.  One, the enterprise can make distributions through time—interest payments (coupons) in the case of bonds, dividends in the case of stocks.  Two, in the case of loans/bonds, the enterprise pays you back, essentially reversing the original transaction (cash for promise, promise for cash).  Three, you can sell your investment, either back to the enterprise or to another investor, which in the case of stock could include another company that acquires outright the company in which you hold shares.

Importantly, companies make interest payments, pay out dividends, repay debt and buy back stocks and bonds previously issued with the cash profits earned from operating their business (or will make in the future).  And, with stocks, when another investor buys your shares, she does so at a price based on the value of the cash profits she expects in the future.  So, any way you look at it, returns rest on cash flows and an enterprise’s ability to generate them.  An investment, properly understood, must include a future stream of cash flows.

Investing versus Trading

Implicit in the definition of investing is time frame.  You give money now in order to get more money back in the future. Investing, properly understood, must also have a reasonably long-term horizon.  If you were to start or buy a private business, say the local car wash, you probably wouldn’t think in terms of “what’s the price I can buy it for today and what can I flip it for next week or even next year.” In thinking about the merits of this investment, 98395489-squareyou’d assess the up-front cash outlay to build or buy the car wash and then the free cash flow you expect the operation of the car wash to throw off each month over the (hopefully) many years to come.

Investing in publicly-traded stocks of companies should, in essence, be no different than the simple example above.  This focus on cash flow generation over time is what sets investing apart from trading, which is what you mostly hear about on financial news channels and from folks doling out stock tips.  Trading is buying something because you believe, for whatever reason, you can turn around and find someone to buy it from you at a higher price. 

Investing versus Speculating

Finally, in the phrase in order to gain, there lies an expectation.  For an investment, properly understood, we must have a well-founded, analytical basis for this expectation.  This is a very important and often under-emphasized, under-appreciated point.  To begin to illustrate it, let’s take an extreme example—buying a lottery ticket.  You give money and may get money back, but you can have no reasonable basis to expect this.  This outcome is a matter of sheer luck, and the odds are long.  This is gambling.

Let’s now turn to the types of financial instruments we typically associate with investing.  For a bond, the cash flows (coupons and repayment) are well-defined in a contract.  For a stock, things are a little trickier.  As an owner, you share in the future profits of the business.  Those future profits are not defined and in fact are unknown.  Nevertheless, stocks can be an investment if we have a reasonably solid basis for estimating what the profit stream is likely to be going forward.  For this to be the case, the company must have a financial track record, and we must discern a pattern in its financial performance, even if it has varied somewhat over time, including as a result of changing economic conditions (through business cycles).

We must also assure ourselves that circumstances have not changed and are not likely to change to such a degree that we can no longer rely on the company’s historical record.  A bond, even with its contractually defined terms, must meet a similar test for us to consider it an investment.  We must determine the company is in a reasonably strong financial position and has a history of generating cash flows that would cover its obligations.

So, bottom line, any investment must pass two litmus tests: (1) it must be based on reasoned analysis and not merely fortune, (2) the reasoned analysis must be based on a historical track record.  If an “investment” fails to meet either of these criteria, it is not an investment, but a speculation.  For a new or young venture, we may pull together a carefully constructed forecast using reasoned analysis, but the forecast has not been tested or proven and reflects our hopes; it is speculative.  The same is true for a company that has been around for some time but is embarking on a significant new line of business or where we speculate that the financial performance going forward will be much better than what it has ever been.

Trading and speculating are not inherently bad.  The market requires some level of trading (though much less than exists today) to ensure sufficient liquidity (your ability to find someone to take the other side of your buy or sell).  Entrepreneurship and innovation, are by their nature speculative, but they are critical in driving tremendous improvements in our lifestyles.  The point here is that for the average investor formulating an investment plan, they are not suitable.  Or are not suitable, except as a small part of an overall portfolio.  The funds that comprise the core of your investment portfolios should hold stocks and bonds that each meet all the criteria of investments, as we just defined them.

Under the Invest tab, I provide examples of funds, both bond and stock, that meet the criteria of investments, and I show how to use them in a diversified manner in the section called Model Portfolios.  In the Stock Funds and Bond Funds sections that follow it, I provide further detail on the long-term investment approaches used by evidence-based funds that I think are particularly compelling.