Many Americans are convinced that publicly traded companies are Ponzi schemes enriching themselves at the cost of shareholders and that the market is rigged by nature. Which leads to the question, What's the point of investing?
Here's my response: The cynics don't know what they're talking about, and worse still, their ignorance is costing them in dollars and cents (not to mention sense).
Let's take the two prime examples of this cynical—you could almost say paranoid—outlook on the market: What is known as the "greater fool theory" and the comparison of the stock market to casino gambling.
Who's the greater fool? The market cynic
Describing the overall stock market as working under the greater fool theory is one of two most ridiculous things I've had to endure hearing over the many years I've been in the securities industry. If you subscribe to this belief, you think that stocks are guided merely by new investors buying out current investors at higher prices for no other reason than the expectation that even more newcomers will come along to buy them out eventually at even higher prices.
The greater fool theory—which is really a version of Ponzi scheme fears—is an overly simple argument that ignores the following five truths about how businesses invest their profits:
- Profits from a business are often reinvested—and that's a good thing! An ongoing business may reinvest a portion of its earnings back into its own operations for innovation, new products and acquisitions and to enter new markets. This is done to both maintain—and potentially grow—profitability over the long term.
- Investors pay up for good companies—for good reason! The key function of a business is to create value by meeting the needs or wants of consumers and businesses. The better they become at that, the higher their profitability becomes, thereby making the company more valuable to potential buyers of the business, either in the form of an acquisition or to stockholders. This is why investors pay up for stocks of companies that demonstrate strong results.
- For every Bernie Madoff, there are lots (and lots) of companies creating value for shareholders. And that's because—and this is one very big reason—businesses are subject to contract law and regulations.
- Shareholders are owners. When one invests in stock, one is really investing in a company as an owner. And as an investor, you are accepting that the management of the business you've hired has what it takes to act in the best interest of all shareholders.
- You can always sell. A stock investor may sell his or her shares on the open market at any time.
"Taking risk on a business is a far cry from playing the odds of a casino that are mathematically proven to work against you."
It's these qualities—and not just new stock buyers taking out current stock holders at ever-higher prices—that determine value. Sure, there are short-term market mechanics, such as short-sale covering, stock buybacks and new equity offerings, that affect the supply-and-demand relationship of available stocks—and can serve to either increase or decrease a stock's value—but these activities have short shelf lives if good earnings results don't soon follow.
And please don't come back to me with penny stocks. This seedy space has nothing to do with the listed stocks that I'm talking about. But if you insist on trading penny stocks, at least allow me to suggest a sell strategy.
Losing bet? Not investing
Now onto the gambling reference. You'd think no one would have to address this one, but I continue to hear it. So let me tell you what the difference is between gambling and investing:
- The longer you gamble, the lower your odds are of winning and the higher your odds are of losing.
- The longer you invest, the higher your odds are of winning and the lower your odds are of losing.
This has to do with giving corporate management the time and flexibility to reinvest earnings back into growth, declare dividends, engage in mergers and perform share buybacks, all of the stuff we touched on in dismissing the greater fool theory.
Sure, you have the risk of any stock going lower after you purchase it, but it isn't gambling. Taking risk on a business is a far cry from playing the odds of a casino, which are mathematically proven to work against you. Corporate strategies need time to work. Sometimes they don't work. But that risk is mitigated by diversification.
I'm done. Now it's your turn to teach this to your children and investing novices.
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Though why should you cynics trust me? I mean, just look at whom I hang out with (see photo above)! You cynics will no doubt read more than you should into this pic, and that's your big problem—a problem that's costing you more than you think. I've got a theory about you: I call it, the Greatest Fools Theory.