Hey guys,
I haven't been around the forum long , so maybe this has already been mentioned in one of the previous investment threads, but I once spent a lot of time getting this straight for myself, and I think there is an intelligent unbiased discussion to be had here. I hope it doesn't incite a riot.
The way I see it, there are 3 types of profit being made on paper assets.
1. Ownership profit. Owners hold their shares. There is really no work involved except checking every once and a while to see that the company is still profitable. The profit comes from the value that the company creates and passes on to shareholders. As an illustration, consider the markets for toothpaste and soda. Toothpaste is primarily provided by 3 publicly traded companies. PG, CL, and CHD. Soda is provided primarily by 3 publicly traded companies also. KO, PEP, and DPS. All 6 of these companies are consistently profitable, and have been for a very long time. American society, and increasingly worldwide society, is set up in such a way that these oligopolies form, and are allowed to operate a fairly lucrative profit margin. In our trade-and-specialization society, they have the rights to provide the toothpaste and soda. It saves time and value for all the people who don't want to make their own. And that value is the "economic profit". Owners are targeting that economic profit by selecting profitable companies to own. They look at historical financial statements to evaluate, and check price second or not at all. Over hundreds of years of economic data, historians have shown that the average return on capital is about 5%. Just look around and you will see the economic value added over the last few hundred years. We live like the kings of centuries ago. Just in tiny kingdoms. Success comes from choosing the right companies.
2. Trading profit. Traders are as old as dirt, the only new part is the stock market. Traders time buys and sells to take advantage of market sentiment. Sometimes the market is a "motivated seller" and at other times a "motivated buyer" as they say in real estate listings. Traders are wheeler dealers. Because stock shares are completely fungible assets in most cases, there is no "fixer upper" factor in trading stocks like in other assets. And because the market is very efficient compared to non-paper assets, traders can't go single out the motivated buyers and sellers. They just have to wait for the market as a whole to adjust. As such, I consider it the most difficult strategy. Two of the trader's main weapons are taken away by the efficiency of the market. They look at historical price charts first, and check financial statements second or not at all. Trading is a zero sum game. Over the long term, averaging out the profits of all traders would equal the 5% long term return on capital (minus much more transaction costs). Success comes from outwitting other traders and correctly evaluating assets. In a way, traders are like appraisers in real goods markets.
3. Market makers. Their profit is the difference between the bid and ask price on a stock. I know very little about this as I have never done it. Markets for most stocks are now so liquid that I assume it is done mostly by computers, and guys standing on the floor of the NYSE. This strategy is not available to your average ERE'er except MAYBE on the scale of extremely micro-cap companies. Market making is more of a job than an investment strategy. They facilitate transactions. They don't look at financial statements, or price charts. All they do is match buyers with sellers and keep liquidity flowing. Success comes from working in a market with, high turnover, high volume, high priced assets, with a large spread.
There are certain other strategies employed, and I basically consider them outright gambling. Nearly every investor uses some combination of 1 and 2. Pursuing category 1 alone is very effective on a long enough time-scale. On a shorter timescale, category 1 purists, aren't doing very well since 2001 for example. But then again, nobody really is except traders who were shorting. Mixing category 1 and 2 together by being a trader in companies which are otherwise very profitable to own anyway is a very strong strategy. However, it is a bit of a job to be outsmarting other people all the time. And obviously it is a gamble because they may fail to win the zero sum game, and in so doing, actually lose their share of the economic profits being created. Pursuing category 2 alone while ignoring fundamentals seems nerve-wracking, and quite frankly ludicrous. These would be the "chartologists" of the stock market world.
Most people are a mix of 1 and 2, and the longer I've invested, the more I've shifted from category 2, to category 1. Because I'd make a bunch of money using category 2, but then I'd lose it again. 1 is where the real value is being created. It's supported by a system wide power hierarchy. It will be profitable from now until some far-off future revolution changes the way that world societies are structured. I can go all the way with only category 1. But if I tried going all the way with only category 2, I will have built a house of cards that comes toppling down if I should ever make a few mistakes in a row. Mixing the two together is good (and I will probably do more of that once I'm retired), but category 1 is the foundation, and 2 is the cherry on top.
