The Future of Investing

I’m trying to work through my confusion regarding how today’s generation of stock market investors think about “investing”.

It’s hard to deny that the inflow of new participants to stock markets around the world over the past few years has impressive. Established geos saw a surge when free trading apps became widely available. And trading volumes in emerging geos are up with the number of everyday people holding stocks on the rise.

But there are signs that these new investors have non-traditional views about what owning a share of stock represents. And these non-traditional views fly in the face of historically sound investing advice.

An important first principle that’s backed up by decades of data is that the enterprise value of a company is highly correlated to how much money it makes. Many studies have been conducted about the strength of this correlation and the conclusion of all of them is “very strong”. In the US, this correlation over the past 20 years for companies on the NYSE or the NASDAQ is north of 0.75 with much of the difference being explained by fluctuations in interest rates.

Simply put, over time stock prices go up when earnings go up.

Where a disconnect is emerging is that the average hold periods for stocks over the past 6 decades has steadily been falling! In the 1960s, a typical US investor would buy and hold shares in a US company for over 7 years. This figure is now below 6 months ON AVERAGE. And I’ve seen the customer hold periods at startups in the space which leads me to believe that first time/inexperienced investors are holding for a fraction of the average.

So, if there’s a clear correlation between earnings and stock price, this decline in hold periods is a narrative violation. Here’s why:

The value of a company is a function of the quality, quantum and durability of its current earnings machine plus a discounted view of the projected quality, quantum, and durability of its ability to earn money in the future.

But the way the market works, the vast majority of information about how a company is performing is released every three months in an earnings announcement. Occasionally there are in-period announcements that matter and other external data sources that can provide context.

And typically this new information is wrapped in a narrative constructed by Management that guides investors and analysts about what the company is doing well, where it’s facing challenges, and how the future is likely to unfold.

So someone can buy a stock with the intent of analyzing all relevant information to determine if the financials and Management’s narrative justify staying the course. Staying implies that analysis concludes that the current and future earnings profile looks attractive.

For these investors, when they buy a share of stock they believe they’re buying rights to a share of the future cash flows of the company. Good management teams will invest in activities that produce even more cash in the future. This is what an investor is buying.

But “investing” can be looked at through another lens. And it’s this lens that’s likely the main cause of the downward trend in hold periods. The alternative view is that the goal of buying a share of stock is to sell it for more than your basis within a time-bounded hold period.

Because the friction on trading stocks has been reduced to zero, many next-gen investors think of buying a share of stock as owning a tangible asset that moves up and down in value every nano-second and can be unwound at any time.

So while the movement in a stock might be due to new information on a company’s performance being shared with the public, many next-gen investors look to buy stocks that have polarized investor communities that systemically create volatility intra-news-period.

Why? Volatility creates opportunities to produce returns when constrained by a limited hold period! Earning a steady 5-6% a year (or even 10%) doesn’t interest investors who aren’t starting with a lot of money in their accounts. It takes doubling up over and over to build something worth protecting.

A more accurate definition of this behavior would be speculation, which in simple terms is the formation of a theory without firm evidence. In the markets, speculation involves seeing volatility as a feature, not a flaw.

And it’s even more complex when you add in the other “benefits” of speculation. Finding polarizing investment opportunities allows an individual to join a movement. And taking a strong position creates opportunities to build social cred and one’s personal identity.

This framework also explains why options have gained in popularity. If volatility creates alpha, the leverage associated with options magnifies the alpha. This also magnifies polarized positions and magnifies social cred. Go big or go home.

But it’s difficult to consistently generate winning positions when you’re effectively buying a slice of a company with an expiration date attached to it. Winning requires getting the entry price, the direction of the stock movement, and the timing all right.

Stories are easy to find about active traders who have 3Xed, 5Xed or 10Xed their money in weeks. More common but less shared are stories of people who bought options and lost everything. A commonly sited stat is that 80% of day traders lose money over the course of a year.

The truth is that I’m not sure what this means for the overall investment space and how to build startups that cater to the needs of this next generation of “investors”. I don’t think this trend is going to reverse anytime soon but I also don’t think it sets new participants up for success.

All thoughts welcome!