The Difference Between Gambling And Investing

Posted On March 7, 2018 2:10 pm

So what about “alternative” assets such as gold, commodities, collectibles, art, or even the newest craze, crypto currencies like Bitcoin. Well these are purely speculative asset types, and I don’t consider them investments at all. That’s because they don’t produce any income, and so the only hope of a profit comes from the ability to sell them at a higher price to someone else in the future.

Or as Warren Buffett explains, ā€œgold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again, and pay people to stand around guarding it. It has no utility.ā€ Now that’s not entirely true since gold does have some industrial uses, as well as in making jewelry. However Buffett is correct that gold is a commodity, meaning that one piece of gold is basically the same as another. So its price is set in global markets, as is the price of wheat, soy, oil, etc.

Now some will correctly point out that commodities can, at times make good investments, and even outperform stocks. That’s because under certain conditions, such as extreme market fear or very high inflation, gold and some other commodities are a good hedge against falling prices in other assets. However for the long-term investor ultimately the best course of action isn’t to sink their money into something that produces no income and thus has little to no intrinsic value. The key to good investing is rather to remember Buffett’s concept of a “margin of safety”.

That means not overpaying for a stock, no matter how great the company is. For example in mid 2016 REITs were red hot and rose into an epic bubble. Dividend favorite Realty Income (O), the “monthly dividend company”, hit a high of $73. This meant it was yielding 3.3% and had a price/AFFO, (REIT equivalent of a PE ratio) of 24. This is undoubtedly a great REIT, and one of the best sleep well at night or SWAN income stocks you can own. But it’s also a company that historically grows at 4% to 5% a year. The dividend grows at that same rate over time, and history has shown that a dividend stock’s total returns usually track the formula: yield + dividend growth.

For example with 4.5% long-term dividend growth, Realty Income at its peak could be expected to generate long-term total returns of just 7.8% (3.3% yield + 4.5% dividend growth). That’s far below both its own historical norms, and the market’s 9.1% total returns since 1871. But now that Realty Income is trading at a yield of 5.5%? Then that same 4.5% long-term dividend growth rate means that it can be expected to generate market beating 10% total returns.

Or here’s a more extreme but famous example. During the dot-com tech bubble, Cisco Systems (CSCO) became the most valuable company on earth, with a share price of $80 and a market cap of $550 billion. The PE ratio hit 240, compared to the broader market’s still crazy 44. The price to free cash flow was a slightly less insane, but still nosebleed 130. Since than Cisco has never come close to its all time high. In fact even with dividends reinvested, Cisco’s total returns since its March 27th, 2000 peak have been -33%, or -2.33% annually.

The point is that if you wildly overpay for a quality income producing asset such as a growth stock, then you are not investing, but in fact gambling. That’s because you are assuming a “greater fool” stance in which you expect to make a profit by selling your insanely price shares to a greater fool than you. He/she in turn will pay that higher price assuming that an even greater fool will buy shares at ever more outlandish valuations. If no greater fool can be found? Then the bubble bursts, and wild optimism is replaced by sheer terror and an epic crash.

About author

Dividend Sensei
Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I currently write for both Seeking Alpha, Simply Safe Dividends, and DividendSensei.com My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams, and enrich their lives. With 22 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams. I'm currently on an epic quest to build a broadly diversified, high-quality, high-yield dividend growth portfolio that: 1. Pays a 5% yield 2. Offers 7% annual dividend growth 3. Pays dividends AT LEAST on a weekly, but preferably, daily basis