Imagine yourself at a Las Vegas casino. The person next to you bets $1000 at roulette. A moment later, the ball lands on red and the gambler doubles his money. Was this person right? A genius? A Nostradamus? Or just lucky? When it comes to a casino, we all know the answer. Roulette is a game of luck. No skill is involved. But when it comes to stocks, crypto, or anything that appears to have slightly more legitimacy than a roulette wheel, we call predictions “right” or “wrong”—this despite the fact that the short-term direction of securities prices cannot be determined on any logical basis. They cannot be. This is not debatable; this is fact. But so many people that acknowledge this common-sense principle when it comes to roulette or coin tosses cannot get it into their head when it comes to stocks. People are so desperate to believe that matters of money must have more certainty than tea leaves or entrails that they implicitly fall—hook, line, and sinker—for the false hope.
When talking head XYZ screams “Buy, buy, buy!” and insists that stock ABC or the Dow is going up tomorrow, he gets lauded as correct or panned as wrong despite the fact that no one could possibly know the direction unless they were trading on illegal inside information. The absurdity is in granting pundits and prognosticators a measure of legitimacy any higher than a tarot-card reader or casino punter. The reality is that all data shows that the short-term direction of a bond, a stock, currency or market is unknowable. The only thing knowable is whether the stock (which represents a legal claim of ownership on an actual business) is an equity stake in a quality company selling at a reasonable price. This can only be determined by looking at the underlying fundamental financials of the company as shown on the profit statement, cash-flow statement, and balance sheet. And this can only lead to predicting a reasonable price appreciation over long-term business cycles of at least 3–5 years. Anything else is noise and nonsense. The key to successful investing is to know what you can’t know.
People think the job of a financial professional is to guess the direction of prices, state that publicly, trade accordingly, and then win or lose. Given that there’s no great investor in the history of investing who has ever employed this method, this dubious “strategy” is most likely to result in complete and utter failure. It’s otherwise called gambling. The great investors—with the audited track records to prove it—like Warren Buffett and the late Charlie Munger, have always followed a different approach: a selection of stocks not based on trying to predict the direction of blips on a screen but rather fundamental elements like cash-flow growth over long periods of time.
There’s another word for gambling, and it’s one that makes it sound only slightly less raffish: speculation. And the difference between being an investor and a speculator is the difference between being successful over time and being successful for a lucky moment. People often think there’s not much difference between speculating and investing: that perhaps the former is just short-term in nature, while the latter looks at a longer time horizon. This couldn’t be further from the truth. They are entirely different acts, borne of entirely different philosophies, and inspired by entirely different underlying mental analyses. It’s tempting to say that being a value investor is just tortoise versus hare. As in the parable, the tortoise’s slow and plodding approach eventually wins the race. There is much to this: value investors have won hugely over the past century—even including the countless periods of enormous technological innovation that have occurred along the way. But it’s not because they approach the race differently. It’s because they are running completely different courses. Though nothing can ever be guaranteed, the value investor knows that companies that generate cash have expected returns that can be reasonably predicted. The value investor still makes mistakes, and nearly always forgoes the most glamorous, flashy, and trendy investments. But the value investor’s concentration on measurable cash flows and the price paid for them renders it the only strategy that respects economics over time. And the only strategy that should be used to plan a retirement.
The worst reason to buy something is that it just went up. The second-worst reason to buy something is that it just went down. The third-worst reason to buy something is because your middle-school friend said you should buy it. The only good reason to buy something is because it’s a quality asset that’s undervalued—again, a determination that can only, only be made by looking at the underlying financial statements.
As soon as speculative fervor returned last year, people quickly forgot how awful it was when momentum/growth strategies had last failed—only months before. The ARK Innovation ETF (ARKK) collapsed 67% in 2022. It then rose 68% in 2023. You may think its mojo is back… until you realize that a 67% loss followed by a 68% gain still leaves you 45% below your starting point. This is the math of reverse compounding. It’s easier to see it in dollars: $100 collapses to $33 after a 67% loss, but returns to just $55 after a 68% recovery—only half its starting value. This is one of the problems with growth/momentum investing. It looks great during short, selected time periods, but due to the astonishing losses it endures, its long-term track records are typically poor. At least growth/momentum investing is based on the principle of buying new and innovative companies that look like they can establish dominance over time. But the problem is that paying too much for any asset—no matter how disruptive, ascendent, or pioneering—is a recipe for eventual failure, even if it leads to huge gains in the short-term. At least growth investing tends to look at stocks as businesses. And this makes it far superior to pure speculation of the type which tries to predict macroeconomic conditions, markets or the short-term direction of securities prices.
Perhaps the worst type of speculation occurs around assets whose value is derived not from the underlying cash flows but from reasons of scarcity. This would include things like crypto, commodities, and raw currencies. Not one of these things produces cash. In each case it can be traded for cash, but it cannot produce cash like real estate or a business. This creates two problems: First, they cannot be valued, because only producers of cash can be valued based on their yield. And second, since they have no yield, you don’t get paid to wait. Many asked me about Bitcoin when it was trading all the way up to $69,000. I never responded that it was overvalued, because that would have been a meaningless statement. It couldn’t be valued. When it dropped from $69,000 to $17,000, the questions about Bitcoin quickly stopped. But now that it’s returned to $43,000, interest is once again percolating. I don’t forgo Bitcoin because I think it will collapse, or because I believe it’s overvalued, or because it won’t go mainstream as a reserve currency. It probably will. I don’t buy Bitcoin for very different reasons: because it produces no cash and cannot be valued, and therefore to purchase it is an exercise in pure speculation, not investing. This is wholly intrinsic to my investment philosophy, one proudly stolen from Warren Buffett. It’s the same reason I would never buy raw yen or pork bellies or platinum ingots. And it’s what’s kept me in business for 27 years as I have watched far too many colleagues file for bankruptcy along the way.
What’s reassuring about value investing is not that it’s always right, or that it always works in the short term, or that it leads one to get rich quick. It doesn’t. It’s that it harnesses economic reality to make sure that every dollar is working for the investor at every minute of the day so that the investor can get rich slowly. And that’s much better than getting poor quickly—which is what most speculators do in the end.