Fundamentals

I recently watched the movie Hoosiers with my two sons. This classic film about the Midwest and basketball offers many valuable lessons, such as perseverance, toughness, hard work, compassion, and forgiveness. This was the first time my sons had seen this movie, set in the 1950s in a fictional town in rural Indiana. The late Gene Hackman plays Norman Dale, an out-of-town coach brought in by a friend to coach the local high school basketball team. Basketball and tradition are everything in Indiana. Dale is thrust into the spotlight with an abnormal but effective way of leading young men. One such way was to get the kids to focus on the fundamentals. In his practices, he had the players focus on passing, dribbling, and conditioning before scrimmaging. This enabled the team to work together as a unit, eventually leading to a State Championship at the movie's end.

When financial markets fall or exhibit unusual volatility, I, too, like to return to the fundamentals and answer a few fundamental questions. This exercise is analogous to practicing fundamentals in sports: conditioning, dribbling, free throw practice, hitting the range in golf, batting practice, speed workouts in distance running, etc. If we can master the small things and the fundamentals, long-range goals will become easier to obtain.

Are you an investor or a speculator?

This is a foundational question we all must ask ourselves. There is absolutely a place for each in markets. In his book, Devil Take the Hindmost, Edward Chancellor discusses this concept in detail. He defines speculation as being active, while investment is passive. He quotes the famous Austrian economist J.A. Schumpeter, who said

“the difference between a speculator and an investor can be defined by the presence or absence of the intention to 'trade,' i.e. realize profits from fluctuations in security prices.” (Chancellor, 1999, p.x)

The legendary value investor, Benjamin Graham, argued for a “margin of safety” when buying assets as investors. He further argued that speculation and leverage, buying investments with debt, were one and the same. (Chancellor, 1999, p. xiii) There is a thin line between investing and speculating. If we are saving for retirement, we must focus on our skills as investors and passive market participants. Does speculation have a place in this? Absolutely. There are many viable strategies. But speculating with the lion’s share of our retirement savings can lead to ruin. We can study the history of financial speculation to see how this occurs time after time.

Why do we invest?

Simply stated, we invest to grow our hard-earned purchasing power and turn financial assets, such as stocks and bonds, into buying goods and services. It’s that simple. The biggest risk we face as investors is that we fail to save and/or invest enough to have the purchasing power to satisfy our spending needs during retirement. There is also the risk of ruin, such as the Dutch Empire at the end of the 18th century, Weimar Germany in the 1920s, or Japan and China during and after World War II. (Dalio, 2021, pp.224-228)

What am I invested in?

Most inventors who participate in a 401(k) plan at work or invest in an IRA sometimes lose track of what they are investing in. The proliferation of mutual funds, index funds, and the like removes us from the underlying investments that provide returns. To broaden perspectives, consider the top holdings of four key categories of a diversified portfolio: stocks, bonds, cash, and gold. I could reference many other investments and portfolio allocation strategies, but these assets will prove my point nicely.

Stocks

Stocks offer investors growth through ownership in publicly traded companies. Stocks can generate returns through the growth of earnings, dividends, and changes in valuation. Investors in stocks should think like an owner. You own shares and participate in businesses such as Apple, Google, Amazon, Berkshire Hathaway, JP Morgan, Exxon Mobil, Nestle, UnitedHealth, PepsiCo, and Costco. Many of us use or buy products from all of these companies.

For example, I use my phone (Google) to check traffic as I fill up my car with gas (Exxon Mobil) to power my car (Toyota) to get to the store (Costco) to buy my energy drink (PepsiCo.) to aid in writing this article on my computer (Microsoft) while waiting for my package to arrive (Amazon). Certainly, the types and makeup of the market have changed over the years, but having the mindset of an owner of high-quality companies that make high-quality products and services is key.

Bonds

Bonds offer returns from interest payments and capital gains earned during the holding period. Think of yourself as a lender when investing in bonds. The benchmark US bond market fund consists of bonds from the US Treasury, mortgage-backed market, and corporate bonds. Therefore, you are a lender to the U.S. government, a lender to thousands of households in America, and a lender to corporate America through corporate bonds. Your loan is secured by the assets of America through its government, real estate, and corporations. In return, investors earn a stable income and predictable payoffs at maturity.

Cash

Investors holding cash can consider this asset a very liquid short-term instrument, typically with a one-year-or-less maturity, which can be quickly sold to purchase goods and services. Cash in the bank represents an unsecured loan to the bank. In the form of US Treasury Bills, cash represents a loan to the US government in return for interest and principle. Cash is often overlooked as an asset class in many portfolios. Cash can provide much-needed risk reduction during market panic and deflationary crises.

Gold

Gold represents the ultimate store of value. Fiat currencies have come and gone, but gold has stood the test of time. It is a world currency that is both timeless and universal. Gold has a historical precedent and has been trusted by societies, rulers, kings, dictators, presidents, and central banks for over 5,000 years. Gold is a “bearer asset,” meaning it is no one’s liability. As an owner of gold, think of yourself as owning “past wealth transmitted down through the generations.” (Gave, 2024, p.8)

Fundamentals

Much of the recent market action involves speculation rather than investing. It’s not normal for the 10-year US Treasury bond to move within a 35 basis point (0.35%) range as it did on Monday. The bond market was breaking on Wednesday due to an unwinding of a leveraged hedge fund trade called the “Basis Trade.” Needless to say, the bond vigilantes were a major reason for the 90-day pause in the tariffs. This announcement caused the stock market to soar, and we witnessed the 3rd largest increase in history for the S&P 500 two days later when it rose 9.5% on the day. These events are abnormal and should not throw investors off their long-range goals. Instead, focus on the fundamentals; living within our means, saving consistently, understanding our risk tolerance, and diversification become the key to long-term success.

References

• Dalio, R. (2021). Principles for Dealing with the Changing World Order: Why Nations Succeed and Fail. Avid Reader Press / Simon & Schuster.
• Chancellor, E. (2000). Devil Take the Hindmost: A History of Financial Speculation. Plume.
• Gave, C. (2024). The General Theory of Portfolio Construction. GavekalBooks.

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