I am planning on starting stock trading, and I decided before I did, I would first layout my philosophical framework for understanding what I am undertaking. I get the feeling that many people engage in activities that they have not fully understood. They may get it right by chance, or even by skill, but disaster will also overtake them because they only understood the smaller forces, not the larger scale ones (for more information on this topic, see this post on seeing to infinity). Understanding something philosophically means that, while you will often get the smaller things wrong, you will usually get the larger ones right.
The stock market and MicroSecession
Now, you may think that stock trading is the opposite of the MicroSecession mindset. And, to an extent, you would be right. I am posting this here precisely because I recognize the dissonance in the approaches to the world, and wanted to explore them for myself and for others. In MicroSecession, we focus on our families and communities, and try to order our lives in such a way as to be able to be impacted much less by macroeconomic and political forces. It also aims to focus on the real over the artificial – preferring silver to dollars, land and chickens and personal capital to stocks and bonds.
So, before I go into further depth into stock trading and MicroSecession, I want to first review the MicroSecession approach to money and wealth. A lot of it is actually borrowed from the financial sector, but applied in such a way that any person on earth should be able to take advantage of it.
- Stop consuming, start producing – focus on hobbies and activities that are productive, not consumptive. Don’t watch TV, write a play instead.
- Purchase capital assets – a capital asset is one that allows you to be more productive. Whatever it is that you are doing, look for things that you can purchase to increase your productivity.
- Convert extra money into hard assets – if you have extra money, purchase things of real, lasting value. The simplest version of this is to buy real silver and gold, either as coins or jewelry.
This is not a get-rich-quick scheme. It is a way to make a tiny, stabilizing move in our modern society. Here are a few ways in which we have implemented this. First, our hobbies currently deal with learning and teaching. We learn (an activity that improves ourselves), and then teach (an activity which benefits others as well as earns us additional money). We produce teaching materials that do the same. We are not great at this yet, especially not great on the selling side, but most importantly, even though we are just eking out money, we are not consuming, but rather producing. Being above the zero line is the primary goal. As for capital assets, most of our purchases are for things related to improving our ability to teach and produce teaching products. Finally, we are indeed converting our extra money into hard assets. There isn’t a lot of extra money, so there aren’t a lot of hard assets. But, over the years, we have generated enough to the point that we have a hard asset savings with a modest value. Not large, not even nest-egg sized, but some. More than we would if we weren’t converting into hard assets. We have some silver and gold, we have some long-storage food, we each have a business bank account that is positive. So, we aren’t in a great place, but we are going forward.
So, if it is working, then why the stock market?
Well, there are a few things that are not working. Christa and I have been both trying to leverage our day job and our individual part-time jobs into larger growth areas. However, for my day job, despite the fact that we seem to be perfectly positioned for it, it just has never worked out. For our evening jobs, we have never had enough capital to really expand the business. All of our books are print-on-demand because we can’t afford a real print run. I can’t afford to take time off of work to write or otherwise develop the business. I can’t afford to hire a marketer to help me make sales. We need capital, but there is no source for friends-helping-friends investing. My hope is, if I wind up making it big, that I can help correct that. I would love to see a local stock exchange where people can easily contribute to the idea and easily take out the profits. But I’m getting ahead of myself. There is no such idea, and there isn’t anyone who believes in our ideas enough to help us move on to the next level, and we are unwilling to go into debt.
Therefore, I decided to take what I did have, and put it at risk in something. If I can’t get a break in my job, and I can’t get a break in my business, and there is no exchange for putting money into local businesses to help them out, I’ll simply go where there is a system and mechanism for putting money at risk to generate profits – the stock market.
However, before I begin, I need to know for myself what is the philosophy of the stock market. What is it that at least should be happening? What is it that people should be gaining? Where does this intersect and not intersect with reality?
Philosophy of Business and Stocks
So, the basics.
What is a profit? A profit, in theory, is the difference between the effort put into the company and the value placed on those efforts by the market. Hopefully, in order to benefit society, those efforts have a real value for society even above the value placed on it by the market.
What is a stock? A stock is a part ownership of a company.
What is the goal of owning a stock? The goal of owning a stock is to participate in the profits generated by the company.
What is the goal of issuing a stock? The goal of issuing a stock is to generate capital to enhance the productivity of the company.
What is productivity? Productivity is the ratio between the effort you put into the company and the total value the market provides.
The goal is that when a company issues a stock offering, it can become more productive, such that each unit of the company brings in even more profit than before. This way, the company benefits by increasing productivity, and the stock purchasers benefit by seeing a share of the productivity increase.
Note that simple expansion is not enough. Actual productivity must increase. If expansion introduces overhead rather than removing it, then the profit will go down, not up. Note that there are always new individual overhead items when scaling up, and also some implicit costs that were never recognized but always there, but, in the final analysis, the overall overhead should go down for increased productivity, or the unit cost should be sufficiently decreased to allow for the overhead.
I like to analyze things like this by looking at what it looks like on the smallest scales. Let’s say that Bill is an accountant. However, he is currently just using paper. He can’t afford a computer because he doesn’t make enough sales, but he doesn’t make enough sales because he can’t afford a computer. If Bill offers shares of stock in his company, then people can pool together money to buy Bill a computer in exchange for a piece of his company. That computer then dramatically increases Bill’s productivity. The increase in productivity is enough to both increase Bill’s income as well as provide a solid profit for the investors.
So, from this, we can deduce the following:
- The final expectation of owning a stock should be profits/dividends.
- The result of investment for the company should be sufficient increase in productivity to benefit both the business and the investors.
- The result of investment for the investor should be a higher return than the maximum of real inflation (about 6.25%) and the treasury bond rate (2.34%). Therefore, our return should be significantly greater than 6.25% if we are going to invest.
- The best way to anticipate future profit is from examining their effectiveness at generating internal productivity.
That last note probably requires some explaining. If inflation is 6.25%, then we can achieve this by just converting our money into hard assets, and then we have lower risk. We can also achieve the treasury bond rate by just investing in treasuries! Therefore, both of these represent a floor (really, a sub-floor – we all want to do much better than this) to what our gains should look like when investing.
Bad Strategies for Investing
Now, there are several strategies for investing that I have heard that I don’t like. I love value investing (it seems to make the most out of the above description) in principle, but the problem with value investing today is that most of the market is way overvalued. For instance, amazon.com is a mature company, but it is trading at a P/E ratio of 511. For a company as mature as Amazon is, this is ridiculous. If we look to the model described previously, this means that it is acting like a bond earning 0.2% per year. That is ridiculous. Apple, on the other hand, has a P/E around 16. That means that it acts like a bond that earns 6.25% per year. Much better! But still not where we want a stock to be at. Here, it is generating a return that is just at the inflation rate, so we might as well be buying hard assets. Plus, Apple lost its innovative touch a few years before Jobs died, and people are finally starting to notice, which doesn’t bode well for the future.
Anyway, having said this, many value investors will just say, “look for the best value.” That is ridiculous. If you are going to be a value investor, you should be looking for actual value. If the market isn’t giving you value, then you should not be investing in it.
Another common option is technical trading, where you trade based on market signals. I don’t doubt that someone can build a system that will spot market signals that no one else sees. However, these systems fall prey to a few systemic effects that few people bother to stop and think about.
The first one is that many systems are simply curve-fitting. That is, someone generated a system that fits old data really well, but it doesn’t actually capture any market knowledge. You see, anyone can fit data into a model. It’s really easy. However, to make a model that actually shows something real is a different animal. It’s also really easy to convince yourself that you made a model of something real when what you actually did was curve fit. I actually have a method to measure this effect, but it is still in development and will have to wait for another day.
The next two are what I call “recursive effects”. See this article for an introduction to recursive effects. The first recursive effect is in that models usually don’t take themselves into account. That is, models are “outside-looking-in” creatures. They tell you what is going on in the room. However, once the model itself is in the room, the room plays differently. A model that works on the outside looking in will often cease to work once it is on the inside, because the model didn’t account for itself. This is why models that are effective for individual investors often times lose effectiveness when it gets public. As long as it was with a single investor, the model itself had little impact on the market as a whole. Once everyone knows about it, there is now a new market which the model didn’t know about.
The other recursive effect is similar. Most models don’t take into account the effect of their own trades on the system. That is, if it looks like IBM is going up, and then I start buying IBM stock like a madman, I am going to trigger other price moves of IBM that might not have happened had I not made the trade. I might have to buy it at a higher price because I was buying! I might have to sell at a lower price because I was selling! Most models don’t take into account these recursive effects.
The final one is what I call “scale effects”. These are similar to the recursive effects just mentioned. That is, when you start doing something at scale, there winds up being problems that you didn’t have before. Perhaps you make a great trade and buy a million shares of stock XYZ at $1 and the price goes to $10. Did you make $9 million? Only if you can also sell it. All of a sudden, having $10 million and having access to $10 million are two different things. There might be interest rates, taxes, overhead, etc., that all come into account once you are at scale that may overwhelm a previously working system.
So, if not value or technical trading, how should you trade?
Here is what my strategy will be:
- Look for places where the market is mis-pricing things. In the current situation, I would look for places where the price is at least 15% off.
- For most plays, buy stocks where I legitimately can see value in holding them. That is, if the stock price went to zero, would there still be value? If so, then this is similar to holding other kinds of hard assets – the value is independent of the present price.
- Leverage using options, with the understanding that the price could go to zero. Options are great because they have a fixed downside risk. It is a way to exercise leverage without having to borrow. You can also short in this way.
The problem with #1 is that the market can continue to mis-price something for a long time. So, you have to be comfortable with that. However, as long as the price discrepancy is significant enough to warrant having your money there, it can work out.
Even shorter, (a) bet against the market, but only where the market is wrong by at least 15%, (b) buy things of underlying value, and (c) use options for leverage and shorting, not borrowing.
Anyway, I would prefer to invest in friends who need capital to enhance their productivity. I would also like for others to invest in me in a similar manner. However, there is not currently a means to do so. Therefore, I will attempt to use the existing mechanisms as best I can using my microsecession understandings to build enough of a base to fund my own way. Perhaps it will work, and perhaps I will lose it all. But I don’t want to be like the man who said, “I was afraid and went out and hid your gold in the ground. See, here is what belongs to you.” (Matthew 25:25).