First, let’s be clear on the difference between an investor and a speculator. Though both use similar techniques, their goals are not the same. Ideally we all make a habit of taking some of our income and setting it aside as savings. Once a critical mass of savings is accumulated there becomes an opportunity to use some of these funds to invest. As often discussed here at Invest-Notes, we advocate considering three primary asset classes for creating and accumulate wealth. Paper assets like cash, stocks and bonds; real estate like homes, rental property and raw land; and other items of value that can be monetized as needed like gold, jewelry and fine art.
Most Invest-Notes readers that I know personally, and those I’ve spoken with, are investors. Their goal is to build wealth over time in a prudent manner to provide for future events like purchasing a second home, helping the kids pay for college or funding their retirement. This requires a regular savings program with the proceeds invested thoughtfully in all three of the asset classes mentioned earlier. It is understood that the greatest chance for success will derive from consistency over meaningful periods of time.
Speculators on the other hand tend to be people kidding themselves that big, short-term bets within any of these asset classes is actually different from wagering in a casino on games like roulette. In both cases the possibility of permanent impairment of capital is the most likely outcome. Using the vernacular, a big bet begets a big loss that makes it impossible to get wealthier over time. Investors are betting on discipline while speculators are betting on luck.
There are however spaces within the spectrum between investor and speculator occupied by people often identified as traders. The obvious suspect is a hedge fund operator. These guys (and they are almost all men, which should tell us something) make big bets based on, for example, deep research underpinned by mathematical models. While attempting to create wealth over time (like an investor) they often try to do so by making outsized short-term bets (like a speculator). And like actors or musicians, where a few become wildly successful, most just don’t make it.
Yet there are times when an individual investor can make a controlled bet on a short-term opportunity. An example would be the purchase of a stock shortly before earnings are reported, with the idea of selling the equity after the earnings announcement regardless of outcome. There are documented examples of stocks that routinely exhibit extreme price action around earnings reports. So an investor who buys an equity based on some insight (real or perceived) with a very small portion of their portfolio (less than, say 3%) in anticipation of an expected outcome (good or bad) can be termed a trader.
Here’s the logic to this assumption. First, the likelihood of a stock going to zero after an earnings report is very small. Worst-case scenario is likely to be a loss of 10% to 20% of the value of the total purchase price. Similarly, unexpected good news will often provide a price gain in the same percentage band. This suggests the most extreme result of a $5000 bet would likely mean making or losing around $1000. And there are additional tax implications based on what type of account the trade is made in. But someone mindful about all possible outcomes of making a bet that won’t have a long-term negative impact on their net worth is not being unreasonable. At least that’s what I tell myself as I generally make a half-dozen earnings season trades annually.
Okay, now to the point of today’s note. The lessons learned from what happened after the Brexit vote might be applicable to a trader’s bet on the outcome of the September meeting of the Federal Reserve (that would be Janet Yellen and team). First, since “nobody knows nothing” as the saying goes, betting against a No Vote carried very little risk since the consensus was so sure of itself. The market impact of a Yes Vote would likely have been negligible since it was expected. Even a bet on a drop of the British Pound, or stock markets in general, were unlikely to generate a big loss. Any bets on the No Vote delivered huge gains for a handful of smart (and lucky) traders.
Second, the ensuing panic over the following week appears to have provided a very good entry point for long-term investors. While I didn’t have the foresight to bet against the No Vote, on both Friday and Monday I added VOO to a couple of IRA accounts. And in analyzing how the Brexit vote played out, it suggests to me a model for what could happen if the Fed decides to raise interest rates at their September meeting. Though, of course, everyone knows that won’t happen. But if it did…
One knee-jerk reaction to a rise in interest rates could be a spike in the value of the dollar – the opposite of what happened to the British Pound after the No Vote. There are a couple of exchange-traded funds (ETF) that move in concert with interest rates as well as the value of the dollar that I’m reading about. And though very dangerous, there are a couple of ETFs intended to deliver returns 2x and 3x the actual percentage increase. Of course this also means double or triple your losses if you get it wrong.
Similar to the reaction caused by the No Vote, a surprise decision to move rates higher – and frankly, even just the suggestion that it could happen in 2016 – would likely drive markets down, possibly dramatically. Having some cash at hand that can be used for adding to long-term holdings during any major sell-off might also prove to be a good bet.
On a different note, all jazz fans are invited to invest some time on Saturday’s with my new radio show, Straight Ahead. At KRTU 91.7 and streaming live online for those of you not in San Antonio, hear great jazz recordings from the 1950’s and 60’s compared and contrasted with new jazz from the 2000’s. Kicking off at 8:00 am, you won’t need any coffee to get your weekend started. And check out the new page in the menu bar above, Jazz-Notes.