I’ve been chewing on the following question for a while, and I’m finally ready to put my thoughts out in the open:
How is trading stocks considered investment?
What follows is my attempt to answer this question.
The difference between “investment” and INVESTMENT
As a small business owner, the word investment has a slightly sinister meaning to me. On one hand, it represents an opportunity, but on the other it represents risk and potential hardship. For example, if I invest thousands of dollars and dozens of hours into building and promoting a new website, the costs of that opportunity are:
- I can’t bill the time I use on my own projects to a client, so I don’t get paid for those hours immediately
- I can’t use the cash for other things like my mortgage, saving for retirement, etc.
- When I make the decision to pursue an investment, I can’t pursue any other opportunities that come my way at a later date
As there are no guarantees that my investment will make money, deciding to invest is not something that I do lightly. If I do decide to invest, I go “all in.” I pour myself into that investment until I get my money back or admit failure. I’m quite certain this is the same process that most businesses follow, and that means that making an investment is a big deal, at least in the business world.
Yet it seems that in the financial world (be it hedge funds or individual IRA accounts), investment is a simple, almost casual process. You buy a stock based on some recommendation, but you never worry too much about the downside. Just set a stop loss and you’re probably OK – you might lose 10-20%.on a single stock, but if you diversify the number of winners should exceed the number of losers.
What’s more, all you need to be a successful stock trader is a good process and a pile of money…and if your pile is big enough, you don’t even need a process. You can just hire someone to do it for you.
Here’s how I break down stock trading compared to business investment
- In stock trading, you can cap your losses. Business investment? Not necessarily. A bad investment can shut your company down.
- In stock trading, you don’t necessarily need skills. You can hire an investment adviser to do everything for you. In the business world, it’s rarely that simple.
- In stock trading, it’s easy to diversify and spread your risk. In business – especially small business – that’s difficult or impossible.
- In stock trading, you can invest and divest as easily as you can click a mouse. In the business world, when you make an investment, you’re stuck in that investment for months or even years.
So let’s go ahead and agree that being a stock trader who makes money is at least a little bit easier than being a business owner or manager tasked with making an investment, and then set that conclusion aside and come back to it later.
Second-Hand Stock Trading Isn’t As Economically Powerful As Business Investment
If I buy a share of stock directly from a corporation, I’m trading cash for a little sliver of ownership in the corporation. The corporation will then use the cash I gave them to turn around and make some sort of business investment, the goal being to increase the value of the corporation and/or generate a profit. If the profits are large enough, they are divided up amongst all the owners (aka shareholders) as a dividend, meaning that I get a check every year (or every quarter) as repayment for my initial investment. What’s more, if the corporation increases in value, I’m able to take my share and sell it to someone else for more than I paid.
But what if I buy a share of stock from someone other than the issuing corporation? The money I pay for that stock goes to the current shareholder, who may or may not be the person who originally purchased the share. This means that my money isn’t going into the corporation’s bank account to help them grow their business…it’s going into some “investors” pocket, and who knows what he or she may do with it. Perhaps they’ll use it to fund their retirement at some point in the future, or perhaps they’ll immediately inject it into the economy by using the proceeds to buy something they need, like a new car.
There’s a key economic difference between handing my cash to a stock trader and handing it to a business. When I hand my money to a business, they could use it to hire workers, build a new plant, or even invent a new product. When I hand my money to a trader, they might buy a car, go on vacation, or they might just keep the money in their account and wait. While these are valued economic activities, they’re not nearly as impactful as business investment.
When a business hires a new worker, it has a multiplying effect on the economy. That new worker is going to buy a house, buy a car, buy clothes, etc. If you hire 100 new workers, they’re all going to spend enough money on these things. Other businesses – such as the local gas station or grocery store – are going to need to accommodate all this new spending by hiring some new clerks, janitors, accountants, etc.. And then these new clerking and cleaning and accounting jobs are going to create more demand for other services, etc., and on down the line.
In other words, when I buy a stock second hand, I’m not doing nearly as much for the economy as I am when I buy it directly from the issuing corporation.
The Opportunity Cost of Stock Trading
If you think about the personal benefits of trading stocks and compare them to investing in business, it’s a wonder anyone would invest in a business at all. Consider:
- There’s far more risk in business investing
- Business investing takes more effort and skill
- Business investing takes time (sometimes years) to generate a positive return, whereas stocks can generate returns in a few hours
While business investing likely offers a greater potential return than stock trading, it’s perfectly reasonable for someone to focus exclusively on stock trading. When presented with a choice between a risky business investment and stock trading activity that’s likely to return 5-10% annually, it’s logical to choosing trading.
The problem is, there are a finite number of dollars in the world. If these dollars are used to invest in second-hand stock trading, they can’t be used to invest in business. Since business investment provides more benefits to the greater economy, the opportunity cost of stock trading is – at least partially – economic growth.
Yet investment is defined by economic growth. Can we call something an “investment” if it doesn’t offer growth, or at least as much growth as the next best alternative? I’d argue that we can not.
I’d also argue that any economically worthwhile activity requires contributions of skill, time, labor, etc. Stock trading – while certainly not easy – isn’t exactly hard. Preeminent stock trader Warren Buffet has said that his job is to “detect the mispricing of securities” – that certainly seems easier than inventing something, building something, perfecting something, etc.
Finally, I’d argue that investments require a commitment. Stock traders can buy and sell a share in the amount of time it takes to pour a cup of coffee – that’s not a commitment by any stretch of the imagination.
To sum up, I would not call trading stocks “investment.” I would call it an economic shell game.
Granted, a vibrant secondary market for stocks makes initial investment much more likely to occur, but let us not forget that share appreciation is not t the only way to earn a return on a stock. Buying and holding a stock is a great way to make money if the issuing company pays a good dividend.
So Stock Trading Isn’t Investment – What’s The Point?
1. If stock trading is not investment, it should not be treated as such in the tax code. It’s smart to have a tax code that encourages investment, but stock trading shouldn’t qualify for reduced tax rates because it’s not as economically important as other investments.
2. Regulations should be crafted to encourage corporations to issue stock, and for investors to buy and hold the stock that is issued. This type of stock trading is investment, and it should be encouraged. Imagine how much easier it would be for companies to obtain funding if issuing stock was an encouraged practice, as opposed to the status quo, where the regulatory requirements and emphasis on short term gains makes it very difficult for most businesses to offer stock.
3. Stock trading should be a little harder. Currently, traders can jump in and out of stocks with almost no penalty. This creates volatility, which in turn encourages speculation. We’ve got people and institutions with millions or billions of dollars sitting on the sidelines, waiting for the right moment to sweep in and buy a mispriced security during an especially volatile moment in the market. If stock traders were required to buy and hold stocks for a few days at a time, volatility would decrease and speculation would decline…instead of billions of dollars sitting on the sidelines of the economy, waiting for something to happen, this money would be in the economy.