- Fundamentally, investing is just putting money to work for future use.
- When choosing between two investment choices of similar risk, pick the one that is more likely to lead to a greater return over your investment horizon.
- However, according to the Efficient Market Hypothesis, consistently making the right decision on this is far easier said than done.
Investing Is Complex (maybe)
The world of investing can be daunting and perhaps even intimidating. Given all the investment options, across stocks, indices, bonds, real-estate, private equity, treasuries, money markets, currencies, CDs, and even artwork, it’s hard to fathom where one should begin when constructing a sound investment portfolio. But as a first step, why even invest in one thing over another? Before we dig into investment portfolios, this post will provide some insight into this simple, but often overlooked question.
In finance, an investment is a monetary asset purchased with the idea that the asset will provide income in the future or will later be sold at a higher price for a profit.
Everyone has that friend, colleague, or associate that made a “killing” in some venture or another, and we all have heard about that stock in the news when it reaches an all time high, or even when the “market” has a record day we hear about it. But what does this all mean, and how does this relate to how you should manage your money?
Investing Is Simple (maybe)
Let’s begin with a simple example. You have Option A, invest in IBM, and Option B, invest in Microsoft. Why invest in one stock over the other? First you need an investment horizon to consider. I’m a strong believer in Investing Forever, and we’ll most certainly discuss why I think this view makes great sense for not only myself but for most investors, but for the time being, let’s assume you have a rather long investment horizon, say ten years.
So, if your horizon is ten years, then the only reason you would pick one option over the other is if you expect one option to have a greater value than the other in ten years time. That’s it. It sounds simple, but answering this question should be your primary goal when deciding to invest in one thing over another. With this goal in mind, you need to consider the more challenging question, which is, “which investment do you think will actually be worth more in ten years time?”
And here’s where the ultimate challenge of investing comes into play. As it turns out, answering this question with confidence is essentially impossible (at least according to theory). It’s not for not trying, however. Almost every investor, including professionals that devote their lives to this task, must answer this type of question one way or another. After all, almost everyone makes investments over their lives, so it can’t be so difficult, right?
The reason behind why answering this question is so difficult is very important to understand, as it’s the basis behind much of financial theory. As the theory goes, markets are efficient, and investments with similar risk should provide similar returns to investors, so investing in one investment over another should not provide a tangible benefit to an investor. This line of thinking is known as the Efficient Market Hypothesis, which grew out of a Ph.D. dissertation by (now Nobel laureate) Eugene Fama. Let’s unpack this very important topic in our very next post as it’s central to investing.
So to conclude this post, here’s a summary of our two questions:
Why invest in one thing over another?
Because one thing will lead to more money than the other.
How do you figure out which one will lead to more money than the other?
You can’t (as the theory goes).
Check out Part 2 of this series to see why many believe this to be the case.