Economics, Risk Management, Trading Education

What should everyone know about investing?

Psychology of trading

Investing is an extremely broad term which comprises countless varieties of capital allocation. For example, one can invest by allocating capital to the stock market, bond market, currencies, real estate, classic cars, antique paintings, etc. Furthermore, various frameworks for investing exist. Two basic frameworks are trading and long-term investing. Trading involves short-term investments which are turned over rapidly (minutes, days, weeks) and long-term investing involves buying and holding investments for extended periods (usually years and sometimes decades).

Corresponding to these two frameworks are technical and fundamental analysis. Technical analysis uses charts and price patterns to predict future changes in security prices while fundamental analysis attempts to approximate the underlying value of an asset. Technical analysis is very useful for trading while fundamental analysis is very useful for investing.

You can probably guess that within each asset class and framework exist countless sub-classes and sub-frameworks. This article will address general principles which apply universally, however, investors must not neglect learning about the specific sub-classes and sub-frameworks which correspond to their investment efforts.

The golden rule of investing

Although there are many principles which direct successful investment, the most basic foundation for success is simply understanding your investment. This may sound absurdly simplistic, however, failure to follow this rule is the bane of countless retail and institutional investors. An easy way to grasp the significance of this concept is through market crashes such as the bursting of the dotcom bubble in the early 2000’s. Leading up to this collapse, tech companies were being financed through equity markets despite having no sustainable business plans, no profit, and in many cases no reason for existing. Middle class workers with no experience in financial markets became stock traders and rode the wave up higher and higher until it collapsed. Many institutional investors also bought the hype and financed these inefficient companies. 

Of course, everyone understood that the internet was going to revolutionize the world in some form or another and they believed that these tech companies were participating in that revolution. Unfortunately, they failed to recognize the difference between that story and reality. If they really understood what they were investing in rather than simply listening to a story, they would have realized that these companies were defective and overvalued in so many ways. This same phenomenon of disconnection from reality has effectively occurred in every type of security across every asset class throughout history. Investing does not mean blindly following the consensus, it means doing your own research and developing a corresponding thesis, whether or not it conforms with the majority. 

Efficient markets: how do investors make money?

Decades ago, Eugene Fama published a theory known as the Efficient Market Hypothesis (EMH). The theory has been presented in multiple forms but its basic notion is that security prices reflect all available information at any given time. The implication of this statement is that investors cannot generate returns above those of the broader market. As a result, EMH suggests that it is pointless to try and beat the market through actively managed investment strategies.

Of course, since there are investors like Warren Buffet who beat the market consistently over time, EMH should be considered false right? Not necessarily. EMH proponents argue that these outperformers are anomalies and the result of probability distributions. That is, given an index of all possible investments and a group of investors buying and selling for the purpose of outperforming the index, some of them are guaranteed to outperform by chance alone. Whether or not markets are perfectly efficient, the underlying concept everyone should take away from this is that investing is extremely difficult and finding an edge is not a casual task. You need to see something that the market consensus does not in order to find that edge. 

Investing for everyone

Investing is the cornerstone of capitalism and individuals who invest their money will generally be more successful than those who spend it on consumer goods. Understanding the necessity of knowing what you’re purchasing and why you’re purchasing it as well as the difficulty of outperforming markets will help everyone avoid scams, compound wealth, and capture the benefits of intelligent investing. 

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