Stop the (Financial) Presses!
Jay
February 8, 2010, 7:41 pm

One thing that has always annoyed me about the journalistic coverage of financial markets is that, by and large, it is geared towards active traders, not investors. What's even more infuriating is that the trading mentality is imbued into the general public. Ask the man on the street one thing they know about stocks and the likely answer is "buy low and sell high".

Yes, you can trade corporate equity. But you can also invest in it as well. The problem is people don't really know how to invest, but they know how to trade. And here's the thing about traders: there are always at least two parties in each trade. You have the buyer and the seller, and both are hoping to make a profit on that trade.

Naturally, one party has to lose out after the trade. If the stock price has gone down, the seller is the one who benefits. If the stock price rises, the buyer's in the black. And when ordinary people try their hand in the equity markets, at best, they're up against other ordinary people. At worst, they're going against the financial titans of Wall Street.

The financial media encourages the trader outlook. Every day there are entries about "hot stocks" that have rapidly appreciated. And the real tragedy is that ordinary people try to ride on the tail end of the trading momentum on these "hot stocks", because once you've heard about the action, it's already past.



Trade trade trade. It's all about capital gains, baby. Sure, every now and then you have an article about dividends or bond yields or something to that effect, but they're often overlooked even as they hold the key to understanding financial markets.

I'm going to assume that the reader (you) doesn't know too much about financial markets. I'm going to assume that you don't really know about the difference between trading and investing in financial assets. So I'm going to tell you the difference, and the implications it has for your financial future. For everyone's financial future.

Trading, as mentioned above, is like flipping a house. You buy the asset, wait a while, and hope the market price for that asset rises so you can sell at a profit. Buy low, sell high. So, what about investing?

Investing in an asset is pouring your money in something that you think will become fundamentally more valuable over time. Notice the key word "fundamentally". What does that mean? It's example time!

For many people, after they graduate high school, they have two choices. They can either pursue a college degree or they can enter the workforce. The person who spends money to try and gain a college degree is investing in themselves in the belief that a college degree makes one fundamentally more valuable than a person with only a high school diploma.

For stocks, it works differently. Let's say you want to invest in Acme Corporation. You buy 100 shares for 10 dollar each. A year later, Acme announces it has manufactured an item that is a foolproof way to capture Roadrunner. An extremely wealthy Wile E. Coyote pays 10 million dollars for the item and Acme's annual profit quadruples. Acme's management then says it will issue a dividend of 2 dollars a share.



Acme Corp's value became fundamentally more valuable because it suddenly gained a lot of money. Money is power, and the company can either use that money to make more money or redistribute it to its shareholders (aka owners). With the announcement of those record profits, other people are suddenly willing to pay you more than 10 dollars per share, even after the 2 dollar dividend is issued.

Because the company's outlook seems bright, its share price rises. At this point, a trader holding onto the stock would sell it and realize a profit. But an investor keeps holding onto it, and if the company keeps making more and more money, the value of the stock becomes more valuable.

When you trade an asset, that asset is only worth as much as what the person next to you will pay for. But when you invest in an asset, you can either reap the rewards yourself (through dividends) or sell it to the person next to you.

A trader doesn't bother waiting for a company's earnings reports or corporate management to work its magic. A trader is only waiting for another person to pay more for the asset than what the trader paid for it. An investor does look at those earnings reports and assess the corporate management and then tries to buy a piece of that company at a fair price.

Now that you know the difference, I want to bring up an example of pure financial ignorance. TIME magazine runs a blog entitled "the curious capitalist" in which the blogger writes about various financial matters. A recent entry entitled "Dividends vs. Capital Gains: Which is better?" displayed poor knowledge about how stocks (corporate equity) work.

The whole point to owning stock is to partake in the future profits of a company. Those future profits are given in the form of dividends. Capital appreciation occurs because investors and traders anticipate that the company will be able to become more profitable over time, therefore they are willing to pay more now to realize those future profits.

When Microsoft offered its stock on the public market for the first time in 1986, it did not issue any dividends that year. In fact, it issued its first dividend in 2003. 17 years later. The reason why Microsoft's share price increased so much between that span of 17 years is because investors and traders reasoned that Microsoft would eventually issue dividends.

The same is happening for Google. Its initial public offering of corporate equity happened in 2004 and it has yet to declare a dividend. But between 2004 and now, the stock has risen from 85 dollars to 533 (2/8/10 at the time of this writing). The reason why is because Google's revenue and profit growth has increased by a similar amount, and investors think Google's earning potential is still strong.



If a company's charter was unalterable and stated that no dividends would ever be issued in the course of its existence, its share price would be worthless. Nobody wants to pay money for a company that won't share its profits to its shareholders.

And with all that said, let's go back to that TIME article. Arguing whether capital gains or dividends is better is pure nonsense. They go hand in hand. A stock will appreciate because people think the future dividend will be higher.

That is the problem with the financial media. Either they are too trader oriented (because you can talk about it daily) or they are completely ignorant about what they're covering. And, as usual, the ordinary person is left holding the short end of the stick.