I expand on a warning given by Warren Buffett
I just noticed a report that Warren Buffett said that trading apps are a driver of the “casino aspect” of the stock market, and traders are gambling on how prices will change in the next 7 to 14 days. He warned “new entrants to the stock market to ponder just a bit before they try and do 30 or 40 trades a day in order to profit from what looks like a very easy game.”
It reminded me that, many years ago, I used a casino analogy to teach a group of pilots and their partners about investing. (The lessons are reproduced as Stages I11 and I12 on Route 2 of Freedom, Time, Happiness on my website. Read them, they’ll amuse you!)
When I first gave the talk it was obvious to the audience that my use of the casino analogy was an entertaining but not literal approach, and that the stock market is not a game. Indeed the teaching session wasn’t about the casino games themselves, but about psychology, in other words, about how to think about the games. I drove home the point that there’s no easy money to be made in an efficient market.
There’s a big difference between investing and gambling. The true investor is setting aside money with a long horizon, hoping (and yes, expecting) that the investment will grow in value because of economic growth. Gamblers have a much shorter perspective and are betting that they are smarter than other gamblers in predicting the course of short-term movements in prices. So gamblers don’t plan to hold funds or securities for long; they buy when they expect a quick upturn and sell when they expect a quick downturn.
In fact gamblers will sell in anticipation of a quick downturn even if they don’t own what they’re selling. How is that possible? Don’t they have to deliver whatever it is that they sold? Yes, but there’s a few days between selling and delivering. So they’re betting that they can sell something valued at $20 today and buy it later (in time to deliver it) when it has fallen to, let’s say, $15. (Not owning what you’ve already sold is called “being short” in the jargon.) This is actually something that investment professionals do too – though I think they’re acting as gamblers rather than investors when they do it. Hedge fund managers, in particular, sometimes bet very large amounts in this way
As I write this today, it seems that the lesson about no easy money in an efficient market is not one that the general public understands. And many think they’re investing when they’re really just betting on short-term movements. The Covid-19 pandemic seems to have generated all too many enthusiastic amateurs who dabbled with their money via those trading apps, made easy initial successes, and assumed that it was their skill that had been demonstrated to work, and that it follows that anything they do will lead to riches. Nonsense!
The fact that they had no concept of (or cared nothing about) the underlying economic value of what they were buying or selling is illustrated by a couple of examples.
The most famous one is GameStop Corp., an American video game, consumer electronics, and gaming merchandise retailer. With no fundamental change in its circumstances, its price per share varied between a high of $483.00 and a low of $3.77 in a 52-week period. There was clearly a lot of scope there to make money and to lose it! Those who bought as it rose (eventually to more than 100 times its initial sober valuation) were not buying because it had suddenly become more valuable, with greatly improved prospects of profitability. No such prospects were ever reported, or even considered. They were buying because the quick rise caused a frenzy of further buying, much of it by amateurs who wanted to buy before it stopped rising – one day its price opened at a level four times as high as it did on the previous day – hoping to be able to sell to another one of them. There’s actually a term for this behavior: it’s called “the greater fool theory,” and it says that it doesn’t matter what price you buy at, as long as you can find a greater fool who is willing to pay even more than you did.
That’s my point. Those who bought and sold weren’t offering different insights on the true value of GameStop; they were betting on the psychology of other market participants. They were gamblers, not investors.
How can this happen, in an efficient market, where there’s no easy money to be made? The answer perhaps requires a narrower re-definition of an efficient market. It has traditionally been defined as a market in which all available relevant information is known to all investors. Well, that was the case with GameStop: no new relevant information about its prospects came to light during the frenzy. What happened was that the gamblers didn’t care about its fundamental data; they cared only about what others might think as the price soared and plummeted. This was clearly an inefficiency they were betting on. Perhaps the definition of efficiency should be restricted to genuine long-term investors, with no gamblers participating. Gamblers can make otherwise efficient markets inefficient.
Another example, less familiar, is Hometown International, a New Jersey deli with a share price that makes its market value more than $100 million. Wow, it must be a chain with massive profits, based on even greater annual revenues, right? Wrong. It has one location only, and the deli’s revenues (not profits, just revenues) amounted to $35,748. Wait, there’s more! That amount represents the combined revenues over two years. So, why the amazingly high valuation? Does “the greater fool theory” occur to you? Or perhaps, as one sarcastic commentator put it: “The pastrami must be amazing.” (Actually it seems that, while the deli is the only operation owned by Hometown International, the stock is used as a vehicle for financial operations, and the corresponding financial revenues are in the millions, but I couldn’t resist the joke.)
Two more angles.
First, what about active management, by investment professionals? Surely it’s genuinely investing when they assemble diversified portfolios based on their own research into the companies involved? My opinion is: no. (I recognize that this will be seen as an extreme position.)
Whatever their passive benchmark portfolio is, that to me represents investing. Their own active portfolio represents their bets away from the passive benchmark, those bets being based on what they expect to be temporary mispricing of the securities. They’re betting that (even when the underlying market is efficient) they are smarter than the other investors whose corresponding research has got the security prices to wherever they are, and that their greater smartness will be rewarded when the prices change in the direction they expect. Their excess return, relative to the benchmark portfolio’s return, is what they have achieved.
To me, the benchmark return is the reward for investing; the excess return is the reward for betting. It’s noticeable that, in efficient markets, the long-term return from investing is positive; the long-term return from betting is typically negative.
The second angle is: am I saying that it’s a bad idea to bet on markets or funds or securities? No. It could be great fun. If you’re doing it for fun, no problem! It’s like going to a casino. Your reward, when you play the slot machines or other games, is the pleasure that comes from risking your money. Any win is a heady bonus. If and when you lose the amount you set aside for fun, you stop. No harm done, lots of pleasure and excitement, and only your “play money” is at stake, just as long as you don’t confuse gambling with investing.
I hope the takeaway is clear: there’s a difference between investing and betting, and there’s no easy money to be made in a (genuinely) efficient market.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.