I have no financial training or credentials. This article represents my understanding from synthesizing many sources of information, but I am likely misusing terminology, and I may be factually incorrect on some points. Apply this information at your own risk.
Don’t invest in anything you don’t understand.
This is the first rule of investing. In a world where people want your money, it’s a good way to avoid becoming mark, swindled out of your life savings. In other words, it’s important to understand:
- What your money will be used for
- Where the new money to pay your return-on-investment will come from
- What the risks are
If investing for building personal wealth has a second commandment, it is to continually pump excess income into low-cost index funds that track a large chunk of the US stock market. It’s not the purpose of this piece to justify this, but mountains of research indicates that this almost absurdly simple strategy—when executed with discipline and an iron stomach—has historically outperformed pretty much every complex investment strategy implemented by active traders, especially once fees are accounted for 1.
I have found these two pieces of advice to be in conflict. This piece is my attempt to sort this out.
Where is the investment?
The word investing literally means that I take money I don’t need to day and I give it to another entity that needs it today. In return, I expect to eventually have more cash out than I put in, either because they have paid me back with interest or given me a cut of profits. It’s pretty straightforward. The philosophical problem I’ve grappled with is that it’s not obvious how buying an index fund constitutes investment, in this most literal sense.
When you put money into an index fund, that manager of that fund buys shares in every company in the index from the secondary market for stocks—the “stock market”. By secondary market, I mean that the money you put in isn’t going to the companies in the index. It’s going to existing shareholders, who are selling shares that they might have bought from the company. But more likely, the shares have passed through dozens of hands since a person or entity actually provided capital to the company. You know: investment.
This is well and good, but the burning questions in my mind are:
- Why should this be the gold standard of personal investing?
- Why does the market reward people so lucratively for not actually investing directly in companies?
- And furthermore, for not exercising any personal judgment on individual companies whatsoever?
It’s been surprisingly difficult to get a straight answer to these questions. I’ve posed them to people I know who are very sophisticated. I often get answers that are vague or too loaded down with jargon for me to understand. But it’s more than an academic question, because those questions underlie the real questions in my mind:
- As index funds become more popular, is dumb money (like mine) indiscriminately increasing the demand for shares?
- Is this just a giant game of hot potato?
- Will this last until and through my retirement?
A proposed answer
As I’ve been needling and challenging folks to draw out nuance, I’ve continued to do my own reading, and combined all of this with the bits of econ I still remember from my minor. I present my two answers, which feel somewhat satisfying:
- Share price extremely important to the executives of every public company, and they will do damn near anything to keep it increasing. It drives their own wealth and the determines the ability of the company to raise capital in the future. So, while they don’t need your money in the form of literal investment, by being a shareholder, you are along for the ride. By being an index fund shareholder, this extends to the massive chunk of equity in American industry that trades on the stock market.
- What you are literally investing in is the cash needs of the faceless people or entities who your index fund is buying a share from. Maybe they’re retiring. Maybe they’re buying a house. Maybe there’s a hot deal they want to participate in. Maybe they’ve lost faith in the US stock market and want to hold cash. Maybe they’re starting a business. Who knows. On some level, the stock market is simply serving our economy as a giant pool to park and retrieve cash. 2
Presumably, the stock market is in a unique position for Answer 2 because whatever spending the seller is using their newfound cash for, that money probably isn’t going too far before passing through the hands of publicly traded companies, helping those companies meet their goals, and increasing demand for their shares.
I guess the brilliance of the whole scheme is that I, as an investor, don’t really need to know who needs my money or how it will eventually help the companies I’m investing in. I can trust in the dollar-based economy to work it out, and I can trust the huge number of active traders on the stock market to determine the value of companies. The lack of specificity of my “lending” of cash to the economy diffuses the risk and increases efficiency, as long as the dollar-based economy remains functional and growing.
The stock market is likely to have crises of confidence and the economy is likely to periodically break down, but historically, things have always recovered and achieved new peaks. Maybe that won’t always be true, but if the trend ends, I’ll probably find myself more concerned with short-term survival than wealth growth.
So to recap:
- What your money will be used for — the general wants and needs of previous investors
- Where the new money to pay your return-on-investment will come from — the increased valuations of companies, driven by the spending and further investment of
- What the risks are — permanent breakdown or devaluation of the dollar-based economy 3
I hope this doesn’t sound too convincing, because I’m still not totally satisfied with this reasoning. But it’s a lot better than where I was before I started asking questions, and I hope I continue to get a better grip on these questions.
If you are an expert in this topic, I would love to hear more perspectives.
See, for example, the Buffet Bet.
Interestingly, it’s not even the biggest such pool of money. The US stock market is $50T, but the US credit market, consisting of bonds and loans, is three times larger. The stock market is much more transparent and liquid, however.
There are also risks inherent to the instrument of an index fund, risks of the dominance of indexing strategies, and risks of the companies that offer them, for argument’s sake, I’m not getting into it.