MODERN
INVESTING
Gambling in Disguise
DAVID SCHNEIDER
Copyright 2016 © David Schneider
Published by The Writingale Publishing
ISBN-13: 978-1537747262
ISBN-10: 1537747266
All rights reserved. No part of this book may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without written permission from the authors, except in the case of a reviewer, who may quote brief passages embodied in critical articles or in a review.
Trademarked names appear throughout this book. Rather than use a trademark symbol with every occurrence of a trademarked name, names are used in an editorial fashion, with no intention of infringement of the respective owner’s trademark.
Although the authors and publisher have made every effort to ensure that the information in this book was correct at press time, the authors and publisher do not assume and hereby disclaim any liability to any party for any loss, damage, or disruption caused by errors or omissions, whether such errors or omissions result from negligence, accident, or any other cause.
The information in this book is distributed on an “as is” basis, without warranty. Although every precaution has been taken in the preparation of this work, neither the authors nor the publisher shall have any liability to any person or entity with respect to any loss or damage caused or alleged to be caused directly or indirectly by the information contained in this book.
The material contained herein is not investment advice. Individuals should carefully research their own investment decisions and seek the advice of a registered financial planner where appropriate.
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TABLE OF CONTENTS
AUTHOR BIOGRAPHY
INTRODUCTION
PART I: THE RATIONAL DECISION
CHAPTER 1: STRANGER THAN FICTION
CHAPTER 2: CAPITAL AND PROPERTY
CHAPTER 3: RETURNS AND CHANCE
PART II: THE METAMORPHOSIS
CHAPTER 4: GAMBLING, INVESTING, AND SPECULATION
CHAPTER 5: WHY WE TURN INTO GAMBLERS
CHAPTER 6: WALL STREET AND CASINOS
PART III: THE DARK SIDE
CHAPTER 7: FORGING THE EDGE
CHAPTER 8: THE BIG CHEATS
CHAPTER 9: PUTTING IT ALL TOGETHER
CHAPTER 10: YOUR CHOICES
AFTERWORD
APPENDIX I: THE GAMES
APPENDIX II: THE PLAYERS
GLOSSARY
ACKNOWLEDGEMENTS
MORE FROM THE AUTHOR
NOTES
AUTHOR BIOGRAPHY
David Schneider
The author of the bestselling book The 80/20 Investor on Amazon in Wealth Management,1 David Schneider bought his first stock in 1994 at age 18. Subsequently, he trained as a commercial banker in Germany and studied finance at London Metropolitan University. He concurrently worked as an Asset Management Trainee and continued as an Equity Research Associate in Tokyo, Japan, where he also studied at Waseda University School of Commerce.
From 2005, he co-founded two hedge funds with a Long/Short Equities strategy working in Tokyo and Singapore. He developed his bottom-up value approach for selecting investment opportunities and managing concentrated portfolios based on the 80/20 principle.
Since 2011 David has been an independent investor, entrepreneur, and writer. On his research blog—NomadicInvestor.com he covers topics including wealth management, financial markets with a critical and independent view, as well as finding investment opportunities around the world.
For performance references, please visit and subscribe to the 80/20 Model Portfolio at NomadicInvestor.com
INTRODUCTION
When I purchased my first shares at 18, investing in stocks felt like playing a game. It was simple. The one with the most cash at the end won, right?
Just like gambling!
That’s right—gambling. Thousands of economists and specialists may get upset at comparing investing to gambling. Yet, no one can deny that today’s financial markets resemble giant casinos with players gambling with their own and other people's money. Before the recent Berkshire Hathaway annual meeting in 2016, Charlie Munger, the vice chairperson and Warren Buffett’s sidekick, had nothing good to say about the current state of American finance. According to Munger, we have "a vast gambling culture, and people have made it respectable."2 Gambling has become respectable in the name of growth—that thing which modern capitalism values above all else and which requires a constant flow of new money—most likely coming from you.
When talking to friends from non-financial backgrounds, I always notice their inner conflict with the topic of money, investing, and all things related to Wall Street. In the end, they give in and purchase financial products that are en vogue or touted particularly aggressively. Once a decision is made, it might feel exciting. They may reassure themselves that everybody is doing it, and experts recommend it until a rude awakening occurs, usually many months or years later. They are not aware that they just have committed to a gamble without a clue as to whether it will ever pay off. This is where the real suffering starts. The dotcom bubble in 2001, the subprime crisis in 2008, the Euro Crisis in 2011, and most recently, the confusion about the economic impact of Brexit—have all caused millions of people to lose money. Regular people, just like you. A brief look at the headlines should have made it clear how challenging this can be.
I remember one of the key lessons I learned from a high school history teacher: “You don't have to be an expert in all of the subjects you are studying. You only have to know enough on each topic, so that you can call bullshit on someone pretending to know more.” When it comes to money and investing, most people simply ignore that crude, yet sound, advice. Often, people embarking on the perilous route of investing do so without a structured education in what investing is, and how it differs from gambling, particularly in financial markets. They don't understand the decision-making process involved and consistently underestimate the roles of psychology and chance. The majority of individual investors, who have no clue how to invest, are easy prey for unscrupulous market players. Common sense gets lost in a mess of financial theory and sales talk by so-called experts.
We all need to ask ourselves a simple question: do we need to play games in the first place?
Thank you for buying this book.
This book is for the novice investor, as well as the crowds of retail investors who feel they need to play “The Money Game,” a term made famous in a book with the same title by author and investor George Goodman (a.k.a. columnist Adam Smith). There is a widespread need for education about money, investing and capitalistic systems, which teaches the basics, but also makes the student think critically and develop a healthy mistrust of an industry that encourages gambling where there is no need, and activity where inactivity would be the more prudent choice.
This book aims to warn all individual investors already invested in stocks and funds, and those who are seriously considering it, to be more diligent about and critical of investing in financial markets and those who want us to play their games. To achieve this goal, we will dive deeper into the mechanisms of investing—its structure, its main players, and the elements of gambling and chance. It is also necessary reading for a much wider range of specific and advanced topics, such as investment strategy, investment selection, or product categories such as mutual funds or exchange-traded funds.
Book Outline:
In the first part, we will take a look at pure investment theory, its history, and ramifications for society as a whole. In the second part, we will explore the commonalities between gambling and investing. We will observe inv
estment banks and brokers, their financial incentives, and how they encourage players to play their games. It will also cover these same institutions—whom I call “game facilitators.”
Finally, this book will examine how the odds are systematically stacked against the majority of players, through the frictional cost of fees, elaborate deceptions, and fraud within games and the entire financial system. On a more positive note, the book will demonstrate that individuals always have their edge that they can use. It will show that we all have a choice, and that there are valid alternatives to Wall Street games. Most importantly, I will introduce a simple strategy that anybody can follow when embarking on the treacherous seas of investing.
Because I am an independent investor and writer, (and to quote Matt Damon), “not running for any kind of office, I can say pretty much whatever I want,”3 I can, and will, be frank with you. I will shed more light on the darker side of financial market investing and its key players, but I will also demonstrate that investing is all about individual choices, that depends on understanding some simple economic principles. With the knowledge contained here, you may achieve returns that far surpass conventional returns, free of Wall Street institutional control.
PART I
THE RATIONAL DECISION
CHAPTER 1
STRANGER THAN FICTION
“The exquisite truth is to believe in something that maybe you know is a fiction, but you believe in it willingly.”
—Roberto Benigni
Have you ever wondered about the nature of money? Its tendency to flow out rather than in? There are powerful forces at hand that dictate the flow of wealth. Investing is part of this invisible force that moves money in our economic system, and, in free markets, plays a significant role in how scarce resources are allocated most efficiently. Investing is all about cash flows—how we command, control, and grow them. The best investors in the world just sit down and let the money flow into their pockets without much effort. Many consider it a game. In the following chapters, we will take a look at investing’s true nature and see that it is very different from gambling and taking just chances.
The Roots of Investing: The One-to-One Deal
The word invest derives from the Latin vestis which means “clothing,” and indeed the history of investment goes back at least as far as the Roman Empire. Indeed one of Rome’s richest men, Marcus Crassus, was a notably savvy and skilled investor—and did rather well for himself until the Parthians poured molten gold down his throat. Investing has been an integral part of the enormous success story we as a species have enjoyed over the last 400 years. It is a crucial part of modern capitalism, where mass consumption and professional investing have become pillars of ever-more growth and progress. But, let’s go back a little, to understand the true meaning of investing and its impact on society in human civilization.
Historically, investing has always been an individual activity. People made money, saved a portion of it and invested it in activities such as trade and farming.
Before the emergence of the first public financial markets, money for large and risky projects (particularly wars) was either raised through taxes or privately negotiated transactions between two parties. Kingdoms borrowing from wealthy merchant or banking families were the norm. They were then able to loot the conquered regions and impose new trade monopolies, while the lenders enjoyed higher status, profit, and access to new lands. For the conquerors, glory, honor and a place in the history books or heaven also worked as an incentive to risk their lives and fortunes. The Athenians, for example, financed large warships to assert their commercial and political interest throughout Greece and the Mediterranean. A few individual Romans financed entire private armies through their trading activities and commercial interests.
Christopher Columbus negotiated a private contract with King Ferdinand and Queen Isabella, which stipulated his share of potential profits—plus fancy titles, such as Admiral of the Ocean Sea and Viceroy and Governor of the Indies. In return for financing the expedition, Ferdinand and Isabella would receive the majority of the profits and a place in heaven for spreading the Christian faith. Put another way; the Spanish crown got access to future returns from any land discovered, and Columbus got money to finance a whole fleet and his expedition. Needless to say, the Native- American tribes were not consulted on how they felt about all this.
One-to-one deals are, hence, the bedrock of human investing activity, but there are some serious drawbacks. At times, the negotiating process in private transactions can get messy, as both parties want to make sure that all their rights and duties are clearly stated, and no misunderstandings occur along the way. All negotiated deals tend to have structural weaknesses and loopholes; and when deals go sour, they must be solved in front of local authorities, which means involving another party.
Liquidity is another issue. After Queen Isabella of Spain finally opened her purse to Columbus, it took several years to see her money returned. Indeed, the first slaves and gold nuggets Columbus brought back from his first expedition were, from her point of view, pretty disappointing. It wasn’t until her descendants’ time that Spain had the infrastructure to capitalize on the New World’s vast silver deposits, and to create huge tobacco and sugar plantations on the backs of millions of laboring slaves.
The Emergence of Stock Markets
Unfortunately for the Spanish, despite being catapulted into the position of a global superpower, their wealth and power did not last. Many of their European holdings rebelled against Spanish supremacy and wanted their independent share of the riches that lay overseas. One such nation was the small area of today’s modern Netherlands, and its commercial center, Amsterdam.
By the 16th-century, everyone in Europe knew of the enormous potential riches that an organized and well-financed overseas expedition could achieve. In the century or so after Columbus’ “discovery,” several Dutch vessels returning from Southeast Asia had returned with cargoes full of spices, gold, and precious stones. What was needed was a reliable system that would provide a consistent stream of money to finance such missions, whatever the size- a system that would incentivize people to give freely and voluntarily. Raising capital from several investors in smaller amounts had its advantages, rather than being dependent on kingdom’s coffers, or the few leading banking and merchant families of Europe. Most important, though, was that it was a system that guaranteed that any money loaned or invested would be returned in full and with a fair share of profits. A system like that had the benefit of opening up the field for stock investing to the public, meaning that the risk of the venture is spread over thousands of small commitments, and not one or two major financial packages from one or two major sponsors.
The Dutch created an innovation that allowed such a system to emerge—the joint stock company. The most famous was called the Vereenigde Oostindische Compagnie (VOC), known in English as the Dutch East India Company. For many scholars, the VOC’s founding in 1602 was one of the most important events in the history of modern capitalism. With their publicly secured liquidity, the VOC established a trade route on a longer, but quicker route over the sea to the ‘East Indies’—the area today known as Indonesia. It financed military operations against less cooperative natives and other competing colonial powers such as Spain.
Control of the company was held tightly by its directors; ordinary shareholders did not have much influence on the company’s direction or access to accounting statements—this was long before management had come to live for “shareholder value.” The company paid generous dividends, and hence a lot of other players wanted in. As intended, they gave their money freely.
One of the stipulations of this so-called aktie, the Dutch word for stock, was that the money invested was non-refundable. However, there were always cases where investors wanted out, due to financial emergencies or cold feet. And so, the first stock exchange in Amsterdam emerged; sellers could exchange their shares for cash from willing buyers. People could bid on the few shares
that were available for purchase, and sellers could demand more than they’d initially paid on the basis of the stock’s likelihood of providing a safe return. The economic law of supply and demand could determine the market price at any day of trading, and the exchange would stand in between buyer and sellers as a neutral party.
The Dutch East India company and many similar enterprises that followed had a voracious appetite for more capital to fund their ever-expanding operations overseas. As long as the ships returned full of riches, investors were assured, and the value of their individual stocks continued to rise and raise the prices higher. But no market is stable forever.
The Definition of Investing
In purely financial terms, investing is often described as “the process of laying out money now, in the expectation of receiving more money in the future.” And,- “the act of committing money or capital to an endeavor (a business, project, real estate, etc.) with the expectation of obtaining an additional income or profit.”4
There is an alternative definition to the above that I prefer and would like you to consider. It comes from Benjamin Graham, the intellectual father of modern value investing and financial analysis:
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”5
According to this definition, there are two components to investing: capital protection and adequate returns. Let’s have a closer look at each core component of his definition and their relationship to each other in the following chapters.
CHAPTER 2
CAPITAL AND PROPERTY
“Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs.”
Modern Investing Page 1