For this 150th issue Moontower, I have a confession.
I write this Money Angle section each week but as recently as 6 years ago, I didn’t really care about or understand investing. The delay in learning has cost returns and even shame. I might as well get the most out of that expensive tuition by sharing the story so others can learn from my mistakes.
When I graduated in 2000, the options and still-new ETF trading businesses were a party. The internet bubble led to high volumes and volatility. The volumes were a step-function higher than anything seen before. I’d estimate prop shops made 4-5x the profits they typically expected.
Before the dot-com days, options trading was a cottage industry where a typical trader could earn a low six-figure pay working relatively short hours without having to ingratiate their personalities to either clients or corporate overlords. A roaring stock market and the emergence of electronic trading transformed the landscape. The existing prop shops and sole proprietors had expertise and so-called time-place advantage on the exchange floors. The competition from banks hadn’t arrived because like I said, it used to be a niche industry. Banks were not internalizing flow just yet. In fact, to play catch-up Goldman paid a shocking sum of $6.5B for Spear, Leeds, and Kellogg after acquiring Hull months earlier.
The upshot. Prop shops were hiring like crazy. I snuck into SIG’s largest ever cohort. I started working in August 2000. I was a trader with my own book by October 2001. (Story time: I finished SIG’s class at the end of summer 2001. I took a 1-week vacation visiting my friends in Cupertino before heading back to NY to my assigned pit on the AMEX. During that trip to CA, my mother called waking me up after a 5am bender. 2 planes had crashed into the World Trade Center. She was in Midtown and called because she “just wanted to hear my voice”. I dismissed her as crazy and went back to sleep. Later that morning, when I turned on the news, it was the worst I ever felt in my life. Only to be topped a few minutes later when I tried to call her and couldn’t get through because the phones were overloaded. When I got back to NY the exchanges were still closed and I wouldn’t start trading for a few weeks).
I was 23-years-old, had my own trading account, and making $100k including bonus. It was more money than anyone in my family made. In the next year, I would pay off my student loans but what would I do with my savings next? Growing up, my parents didn’t have extra money to invest. I didn’t learn about compounding and what 100 bps means in the long run.
There was also a perverse combination of influences that kept investing in markets off my radar. First, the bursting of the internet bubble made me feel thankful for not investing in stocks. Second, as a trader we were trained to have no opinions. I thought of option customers as deluded gamblers. Suckers and tourists unless they had inside info. As market-makers, we were always worried about toxic flows. Toxic flow is informed flow. It’s either flow frontrunning a larger incoming flow or straight-up insider trading (I clerked at the post were options on XAL traded. That’s the AMEX Airline Index. Put option action before 9/11 was investigated with attempts to trace profits back to Al Queda. No smoking guns were found). In my model of markets, you either cheated to make money or you were the casino. Otherwise you were just gambling. Pretty dark.
I was starting to accumulate savings with my debts paid off. SIG had 401k matching so it seemed like a no-brainer to put money there. I think I just used a target-date fund. It was a snap decision. Retirement felt really far away so money trapped in a 401k felt fake to me. Later, when I was self-employed I would contribute $50k/year to a SEP IRA and just jam it into stocks. Again, fake money since half of it would have been taxed if I didn’t contribute.
But what would I do with liquid savings if I wasn’t going to invest beyond a 401k? The default was to buy a place to live so I wasn’t “throwing money away on rent” (that’s the wrong framing of rent; learning is unlearning). With this goal in mind, I was focused on saving about $75k for a down payment on an apartment. As a near-term goal it was money I couldn’t afford to lose, so investing didn’t make sense anyway.
In 2005, I bought a coop studio in midtown on 57th between Lexington and 3rd Ave. It was a 450 sq ft fixer that I renovated. (Random: the apartment was above a memorabilia store that had a Guns N’ Roses VMA award presumably from the night Duff and Slash, stumbling drunk, accepted the moon man while slurring their words and cursing on live TV. They were asking $5,000 for it. The most burning missed trade in my career.) Between the apartment and renovations, my savings were now depleted to a healthy reserve. No reason to invest.
2 years later, I score a low seven-figure bonus. So what do I do? I buy a condo in LIC off of plans. Paid the developer’s costs and everything. It was 2007 in NYC. That’s how it was. Toppy.
By the time the place is built and I move in, the GFC is in full swing. I never had great timing. (Not even as a vol trader…that’s why it’s critical to manage risk and size well. Timing is impossible to nail consistently but it’s not as important. Harley Bassman likes to say “sizing is more important than entry level”. Co-sign.)
I was in the midst of taking 6 months off after leaving SIG to start my own trading business with a backer. I’m shopping for an engagement ring, expect to have big wedding expenses in the next year, and embarking on a new venture where I’d have to post cash in escrow with the backer. Plus I’m watching the financial world implode. With all these demands and an apartment that is immediately underwater from its basis, there was no way was I going to stick money in the market.
So here I am, I just turned 30, a trader for 7 years, and I still don’t know a thing about investing.
I won’t drag out the next decade in detail, but I remained apathetic about investing. When we moved to SF in 2012, we started looking for homes. Another imminent purchase, so no point in investing, right? Since I don’t understand investing I figure I’ll just buy a house in cash and at least lock in the after-tax mortgage rate as a return. I know, I know. (Look, writing this is part of the healing.)
We can zoom ahead until about age 36. We just bought our family house in the ‘burbs and have a 1-year-old. This focuses you on the future. While my wife and I enjoy substantial W2 incomes, high taxes and relaxed spending habits make something abundantly clear — the strategy of just outrunning will eventually tire. I’m sitting there without equity in anything except a house.
That’s when I turned to the internet. I started lurking on Twitter. Listening to podcasts. I approached investing with a beginner’s mind. I realized that my trading background actually harmed me but it was because of how I generalized its lessons. It was my own failure. [See: How I Misapplied My Trader Mindset To Investing]
I became swept up in a process of unlearning and reconciling. What about trading applies to investing? The answers are still unfolding for me. When I started this newsletter I was mostly sharing links and concepts I found interesting. Somewhere along the line, I began translating from one domain to the other. The feedback told me that people outside trading could learn from the niche I spent my whole career in if I could peel off the skin to get to the fruit.
The quest to get better at investing goes hand in hand with learning and teaching. Some of the cornerstones from which I approach investing education:
- Markets, from the perspective of most people, are “efficiently inefficient”. Efficiency is highly seat-dependent. Sitting in the cockpit at my last job, I could see inefficiency. I have no such visibility from my living room. My experience in trading has paradoxically contributed to this view — I’ve spent a lot of time in awe of how something that I thought was clever was actually priced in before I got there. That’s a hint that the relative efficiency of markets is not a paradox.
- I can appreciate others being incurious about investing (I still consider it a chore…I find finance conceptually fascinating but investing is about a lot more than concepts). So I’m sensitive to people’s preference for simple. Investing is a wicked domain with tremendous luck. One of my favorite statistics comes from my buddy Nick Maggiulli. The dates are cherry-picked but somebody lived them:if you had invested from 1960-1980 and beaten the market by 5% each year, you would have made less money than if you had invested from 1980-2000 and underperformed the market by 5% a year.
The returns to effort diminish extremely quickly. Charley Ellis describes investing as “a loser’s game” like amateur tennis. You win by not losing. Not making giant errors. Not carrying 18% credit card debt. Not concentrating your wealth in the latest shiny rock. - Not everyone grows up knowing about compounding. There’s a lot of financial literacy stuff for kids or teens out there. Much of it is impractical unless the youth is specifically interested in investing. Yet the idea of compounding, not just financially, but in relationships, knowledge, and skills is critical. Finding ways to deliver this message so that it sticks is a worthy challenge.
- Separate what matters from what doesn’t matter. Investing is a playground for decision-making. You can be doubly helpful if you can help map investing rationale to general thinking. A hunch — the best lessons from investing and portfolio theory are more useful outside investing.
My last confession for today. I didn’t really understand where equity returns came from for most of my adult life. I thought that over time “stocks just go up” without any sense of why. That’s just willful ignorance at some point. I wanna believe I knew where returns came from if you pressed me but I’m not sure. Either way, I’m sympathetic to others who don’t get where returns come from.
A non-zero percentage of people who invest in RE fall in this camp. There’s something about them not being able to see the cashflow that makes them think stocks are fairy dust and not businesses. The whole dividend darling marketing spiel is aimed straight at them even though dividends are tax-inefficient.
[The decision to pay dividends or not has nothing to do with whether a company is a good business. It’s a capital allocation decision. Jake uses a simple picture to show they are mathematically equivalent to buybacks. Stock prices fall by the amount of the dividend. If you have ever exercised a call option early you know this. In fact, when you see the “change in price” column in a data vendor after a distribution, that change is net of the dividend. So if a $50 stock pays a $1 dividend and the next day is trading for $49, the vendor will say the stock is “unchanged”.
Dividends, just like the buybacks, reduce the amount of cash on a company’s balance sheet. In the case of the dividend, the price of the stock falls reducing the company’s market cap by the amount of cash they spent. In the buyback scenario, the price of the stock remains unchanged but the shares outstanding falls. Again, the market cap falls by the amount of cash the company spent.]
It’s totally understandable to have mistaken beliefs about where stock returns come from. All of the charts we look at are price charts. How many charts do you see of earnings or FCF in mainstream financial outlets? It’s not nefarious but it makes you wonder. How can financial content be displayed so that it improves our understanding? How can investing education be incorporated effectively into pre-teen and teen education?
I’m a trader and a lot of investing basics managed to avoid me. It’s understandable. People’s asset allocations are not openly discussed. There’s so much financial information online but it’s hard to know what’s trustworthy especially when you are a beginner. There’s no brand that comes to mind as the obvious choice for financial literacy.
As I continue learning, I’ll keep doing my small part to share and educate. There’s work to be done here.
*Special thanks to Nick and Jake. We had dinner a few weeks ago and the seeds of this post fell out of that conversation. We were also celebrating the early success of Nick’s outstanding book Just Keep Buying. I have read nearly all of Nick’s blog posts and when I came to investing it was formative. Now you can get all the lessons in one tidy place. And there’s a kicker — the book is better than the blog. So even if you read Nick regularly, the book is worth buying. It’s also a perfect book to give someone when they are in high school or college or their early 20s.
If I had this book back then, I never would have written this post.
Damn that thought has major Terminator plot vibes.
When I started learning about investing, this post would have been welcome:
✍️Return: Where Does It Come From? (11 min read)
by @kbracker
This is an evergreen post fundamental to investing education. It explains the components of equity returns.
Kevin Bracker is a retired finance professor.
His YouTube channel is epic. In-depth examples of fundamental, quantitative, and derivative concepts. Check it out.