Have you ever used a tool for something it wasn’t designed for? Perhaps you instinctively grabbed a towel bar for balance when stepping out of the tub, only to rip it from the wall as you fell. Or maybe you stood on a chair to change a light bulb, discovering as you fell to the floor that it was a poor substitute for a ladder. In these common scenarios, the towel bar and chair weren’t faulty; they were simply used incorrectly. Good tools, when misused, can lead to injury or significant damage.
Similarly, investing, lending, and speculating are three distinct financial tools, each with a specific purpose. We’ve observed that significant financial challenges can arise when these tools are confused or used interchangeably.
Our investment philosophy is built on the goal of participating in the rewards earned as an owner of businesses. This approach to investing is distinct from both lending and speculating. We believe understanding these distinctions is crucial, much like using any tool for its intended purpose.
The Investor as Owner: Participating in Business Success
When you buy a company’s stock, you are getting an ownership stake. This means you become a part-owner of a real business, including its assets, intellectual property, and talent. As an owner, you are positioned to potentially benefit from the company’s long-term growth in earnings, revenue, and innovation.
The rewards linked to business ownership don’t follow a fixed calendar; they may materialize at irregular intervals. This is a key difference between stock investments and owning bonds. A bond owner, acting as a lender, expects repayments on a contractual schedule, providing a defined stream of income and principal repayment.
As a stock owner, however, you share in the business’s residual returns – the free cash flow that remains after all expenses. A well-managed company typically aims to generate free cash flow. This capital can be used to enhance the business’s value – perhaps through modernization, expansion, or research and development – or it can be returned to investors via dividends or share repurchases.
Our focus is on investing; that is, finding businesses with management teams dedicated to building value over extended periods. We seek companies that, through their operations and strategic decisions, have the potential to become more valuable over time. This investment-focused approach is what truly differentiates it from speculation. We are not attempting to “flip” an asset, hoping to sell it to someone else for more money. Instead, we aim to own a business that increases in value over the long term due to its underlying success.
Why Investing, Lending, and Speculating Need to be Kept in Separate Cages
Significant issues can arise when these distinct financial tools – investing, lending, and speculating – are confused or inappropriately combined. To use a different analogy, you could think of them as different animals that should be kept in separate enclosures.
The Pitfalls of Confusing Lending and Investing
Consider what happens when lending gets confused with investing. For example, someone seeking contractual, periodic returns from a bank CD or money market account might see a security offering a much higher interest rate, say 7% versus 4%. While more seems better, a 7% rate almost certainly involves significantly more risk than a 4% rate. For why would anyone willingly pay 7% when the prevailing market rate is 4%, unless there was a clear underlying reason, such as increased risk?
In such a scenario, the person offering money at 7% isn’t merely a pure lender; they’re also absorbing the risk of whether there will be enough cash to make those contractual payments. It’s a very real possibility that after a few 7% interest payments, the principal is never returned. Receiving 7% on your principal is appealing, but securing the full return of your initial principal is even more important.
To properly evaluate such an opportunity, you’d need to think like an owner, not just a lender. Can the underlying business’s cash flow truly support these high interest payments, or is this a desperate grab for funding? If your goal is regular payments and the assured return of your initial investment, you’ll likely need to consider a more certain arrangement than being a quasi-owner. Investing and lending are two different animals.
Why Speculation and Investing Don’t Mix
Another common pitfall occurs when somebody mistakes speculating for investing. It’s easy to think that investing is simply buying low and selling high. While earning a profit is a goal for both investing and speculating, there is a fundamental difference in how each approaches this objective.
Investors aim to understand a business’s future cash flows and how these can build underlying value. A speculator, conversely, focuses primarily on price, attempting to predict when an asset can be bought and sold for a profit. For a speculator, the existence of an underlying business isn’t even essential; the asset could be Bitcoin, gold, “meme stocks,” or anything with a fluctuating market price.
There’s nothing inherently wrong with speculating, especially if you’re one of the rare few who possess a knack for predicting asset price movements and market sentiment. If you use funds not needed for other critical purposes (like retirement), speculating can even be exhilarating. However, we’ve encountered individuals who believe they “have to” speculate because they “don’t have enough money for retirement.” This can potentially bring severe consequences, asinvesting and speculating are truly different animals.
This distinction is also why, if you ask us about assets like Bitcoin or gold, our standard answer is that we don’t consider these investments, but rather speculations. We aim to earn the rewards typically associated with business ownership. Gold and Bitcoin are not businesses, and therefore, they do not align with our definition of investing.
Our Ownership-Oriented Approach
Our investment philosophy is built on the belief that holding shares in strong businesses for the long term offers a compelling path to wealth creation. This strategy emphasizes patience, discipline, and a focus on the fundamental strength and future prospects of the companies you own. By keeping investing, lending, and speculating distinct and in their appropriate categories, we aim to help you build a financial future aligned with the productive growth of the economy.
We encourage regular meetings to discuss important topics like this together. If you have further questions, please feel free to call us at (402) 991-3388. We are here to be your sounding board.
Eric Ball, CFA
Managing Director & Chief Investment Officer
America First Investment Advisors, LLC
Omaha, Nebraska
Disclaimer: Please remember that investment advice and financial strategies involve risk, and there is no guarantee that your financial goals will be achieved. The information provided in this article is for general guidance only and does not constitute personalized financial advice. It is essential to consult with your financial advisor, a tax consultant, and an estate attorney to discuss your specific circumstances.
