The Power of a Single Word
It has been a while! We were busy writing an important amicus brief in SEC v. Coinbase, and we’ll publish a post summarizing our position on our sister blog, Full Court Press soon. Once again, the definition of investing is at the forefront in this case, and we strongly believe a proper resolution requires addressing two questions simultaneously: First, the finance question: Is it an investment? Second, the legal question: Is it an investment contract?
We have also been quite busy creating our official New Finance Institute website. We are very happy how this turned out and hope you like it too! Among other things, we have added a total word count. Can you believe we have already written over 48,000 words for this F27 blog alone? That’s the length of an average nonfiction book. We also added a sample of popular posts, which is something we will update periodically.
With these two major milestones completed, we are back to publishing our regular posts. Further, since the concept of “value investing” is so central to the definitional problem with investing, we want to spend a little more time with it. You might recall, back in June, we focused on personal profiles when we were discussing the Bitcoin “investing” myth. We felt this was important because myths don’t survive and thrive unless there are flag bearers with significant public profiles. Whether they intentionally follow the myth or truly believe in it is beside the point; either way, they have strong opinions, they get mindshare, and contribute to the misconceptions surviving, sometimes being handed down from generation to generation.
So there are definitely a few “value investors” that we will begin profiling over the coming days, but before we start doing that, let us reiterate why the concept of “value investing” is so important. Remember this infographic?
The reality is that investing is only a small sliver of the entire trading universe. In the alternate finance world we live in, that small slice has been recharacterized as “value investing.”
You might say, so what? It’s just a name. Well, everything is in a name. You might not think that much happens when we add just one word to an activity. We beg to differ. It changes pretty much everything. Let’s follow through with the implications, shall we?
Step 1 - Investing Expands
A picture is worth a thousand words, so it’s best to look at it visually. Below, we stripped various elements of the visual above to focus on the expansion.
In the world of alternate finance, investing becomes much larger, encompassing both true investing and speculation.
Step 2 - Trading Becomes Investing
We are still in visual mode. This time, we played with our starting image in a different way.
When investing becomes value investing (see the lower end of the visual), it results in a parallel misconception: trading becomes investing.
Step 3 - Speculation Fills The Gap
So, when investing becomes value investing (right side of visual), there are two main implications; they are really the two sides of the same coin. Investing expands (Step 1 above), and trading becomes investing (Step 2 above). Then what?
What happens when you have more time to do something? Parkinson’s Law states: Work expands so as to fill the time available for its completion. A similar idea applies here. The way we see it, here is the finance version of Parkinson’s law:
Investing expands so as to fill the space available for trading.
Said differently, speculation starts filling the gap, precisely what Ben Graham warned us against, in his seminal book, The Intelligent Investor:
There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are:
speculating when you think you are investing;
speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and
risking more money in speculation than you can afford to lose. (emphasis added)
Step 4 - Much of Stock Market Trading Becomes Speculation
How much of the stock market trading is speculation? Well, nobody really knows. In fact, the figure is unknowable. Why? Because whether a trade is speculation or investing depends on the value of the stock, which cannot be known, even over time. Has the price truly converged to value? Or, did other material events happen, and the value itself changed?
The point, though, is not in knowing what the exact percentage of the stock market is speculation, it is more about trends. Do you think there is more speculation happening today, than 20, or even 10 years ago? We feel one would be hard-pressed to conclude otherwise.
You might say, so what? Well, if you are a believer that one of the most important functions of capital markets is the efficient allocation of resources, then excessive speculation would mean that most people are interested in making a profit regardless of where the true value of the stock lies. That, in turn, would mean that not many people are looking to explain the price-value differential (which is what true investing is all about). That would mean that it takes longer for price to converge to value. In fact, it may never get there, especially for small caps that may or may not have the wherewithal to weather the storm.
Related or not, this evolution also coincided with the rise of retail trading. Jay Clayton, former SEC Chair, makes the same point here:
Here is how he describes this new paradigm (note that we do not agree with his characterization of this activity as investing):
[T]here is a new paradigm. There are more retail investors participating in the market than ever before.
What to do? No matter how much speculation there is in the stock market, the solution is more educational than regulatory. As Jay Clayton noted:
We regulate disclosure, we regulate trading… one thing that we don’t regulate, directly, … is euphoria.
We don’t disagree. That said, if a space needs to be filled with speculation, new “assets” will eventually come to life…
Step 5 - When Trading Becomes Investing, It Leads To Undeserved Parity
Remember our version of Parkinson’s Law: Investing expands so as to fill the space available for trading. Once speculation had room to expand, there was no reason to think it would stop with what we call Type 1 speculation: purchasing cash-flow-generating assets, but paying dearly for them. Instead, a whole new type of speculation, what we call Type 2 speculation emerged: purchasing assets that do not generate cash flows.
For this type of speculation to emerge, it needs an asset that it can bind to. Gold filled that gap for a while, but it is hard to store and gold futures are not exactly the same thing (limited access, shorter-term instruments, etc.). If there were just another asset that could serve as an “investment” vehicle, one that you can buy with a click of the mouse, and one that you don’t have to store, wouldn’t that be amazing? This is the environment Bitcoin was launched into.
We are not saying that Bitcoin was created for the sole purpose of speculation. It is entirely possible that Satoshi truly believed in a new monetary paradigm. What we are saying is that the innate desire for individuals to speculate must go somewhere, and Bitcoin gave that desire an accessible outlet.
Moreover, it is hard to duplicate gold. There are obviously various other metals, but they have to exist naturally. With crypto tokens, it’s all made up anyway, and the laws of nature don’t apply. That created a boon for the supply-side industry.
Thus, new “assets,” and speculation in those assets filled the gap. As illustrated above in the Alternate Finance visual, every trade became investing, anyway. As a result, a parity has been created between stocks and crypto, a parity that crypto does not deserve. As one of our favorite articles, Your father’s stock market is never coming back [paywall], states:
With a Robinhood account, your first exposure to cryptocurrencies does not frame them as an unproven alternative to stocks. The two stand on equal footing. Coke and Pepsi. Feel like trading one or the other? Have at it, no difference. This is radically different from the experience of the Gen X and boomer investors … The generation creating the new conventions of the investing landscape views stocks and crypto coins as interchangeable. (emphasis added)
This perfectly describes the current world of finance that we live in. Unlike Type 1 speculation, we believe that there actually is a potential regulatory solution for this phenomenon, but it may take us a while to get there.
What we don’t see happening is anyone providing an explanation as to why we have this parity. How did we end up here? We need to understand the reasons to address the problems it creates. We strongly believe these problems will become exacerbated with the Bitcoin ETFs that are on the horizon.
This post fills that gap by directly speaking to the why. As we always say, the issue is definitional, with the most consequential definition of all being “investing.” Taking it one step further, the definition of investing has gone haywire, because of that one word the finance world has decided to attach to it, despite on-record clarifications from Warren Buffett, arguably the greatest investor of the last half-century. Ben Graham would have certainly not approved it, either.
The word “value” has many positive connotations, and rightly so. In finance, it is attached to cash flows. It also means “something (such as a principle or quality) intrinsically valuable or desirable.” A valuable asset and a person having values are desirable concepts.
The biggest irony in all of this is that adding that great word, “value,” to another word with positive connotations, “investing,” is destroying a lot of value. It not only does so by effectively transferring wealth from unsuspecting individuals to the beneficiaries of the speculation ecosystem, because those individuals keep speculating under the guise of investing, but it also goes against the fundamental principles of truth, transparency and fairness.
