The Language of Investing

So much of our conversation assumes that each word has only one meaning, no matter who uses it.  But my experience is that different people have different definitions for the same words–which is one reason I think there is so much confusion surrounding investing today, and why I think it is useful to look at the multiple definitions that exist for some common investment terms.

I want to start with what most people might think are statements of investment fact, but that I think are statements of investment opinion:

Statement 1:  Stocks are riskier than bonds.

Statement 2:  You need more than one mutual fund in a diversified portfolio of investments.

Statement 3:  Retirees need income.

The truth of these statements depends on the definitions of seven key words, so I want to look at these words and their possible definitions.

  1. Stocks – Conventional Definition:  Stocks are pieces of paper that can be bought and sold.  Muhlenkamp Definition:  Stocks are a way of owning a piece of a business.
  2. Bonds – Conventional Definition:  Bonds are more pieces of paper that can be bought and sold. Muhlenkamp Definition:  Bonds are a way of loaning money to a business.
  3. Mutual Funds – Conventional Definition:  A Mutual Fund is a collection of paper. Muhlenkamp Definition:  A Mutual Fund is a professionally managed, diversified portfolio of investments.
  4. Investments – Conventional Definition:  Investments are the sum of all the pieces of paper you own that you hope to sell for more than you paid.  Muhlenkamp Definition:  Investments are assets* that you believe will be worth more in future.
  5. Risk – Conventional Definition:  Risk is the degree to which the price of a piece of paper moves up and down in a short period of time.  Muhlenkamp Definition:  Risk is the probable loss of purchasing power over time, usually due to taxes and inflation.
  6. Diversification – Conventional Definition:  Diversification is owning all the pieces of paper you possibly can so that random price movements cancel each other out. Muhlenkamp Definition:  Diversification is having at least twenty different investments so that being wrong about some of them doesn’t wipe out your assets.
  7. Income – Conventional Definition:  Income is interest and dividends. Muhlenkamp Definition:  Income is the cash flow produced by your investments, which can take the form of interest, dividends, capital gains, and principal.

Now, if you agree with the conventional definitions of these terms then the statements I listed above are in fact true.  Using the Conventional Definitions, these statements become the following:

Statement 1:  “Stocks are riskier than bonds” becomes “The prices of some pieces of paper move up and down more rapidly in a short period of time than the prices of other pieces of paper”.

Statement 2:  “You need more than one mutual fund in a diversified portfolio of investments” becomes “You need more than one collection of paper to have all the possible pieces of paper so that their random price movements cancel each other out.”

Statement 3:  “Retirees need income” becomes “Retirees need interest and dividends.”

So Conventional Definitions lead to true statements, but I’m not sure how useful they are.  But notice what happens if you substitute Muhlenkamp Definitions in these statements:

Statement 1:  “Stocks are riskier than bonds” becomes “Owning a piece of a business will more probably lose your purchasing power over time than lending that business money.”

That isn’t true.  In fact, Ibbotson has shown that after taxes and inflation, returns from stocks have outpaced bonds by 40 to 1 since 1925.

Statement 2:  “You need more than one mutual fund in a diversified portfolio of investments” becomes “You need more than one diversified portfolio of investments in your diversified portfolio of investments.”

That seems silly.  How many diversified portfolios do you need in your diversified portfolio?  Isn’t it possible to hire one person and give him the task of selecting assets for you that he believes will be worth more in the future?  Shouldn’t his priority be to make sure he doesn’t lose your assets by using enough different investments that being wrong on a few of them doesn’t wipe you out?  How many different professionals do you need to do this for you?

Statement 3:  “Retirees need income” becomes “Retirees need cash flow produced by their investments, which can take the form of interest, dividends, capital gains, and principal.”

This is a true statement, but it is a very different statement from the one you make with the conventional definition of income.  With the Muhlenkamp definition, retirees can spend income, capital gains, and (if necessary) principal.  In fact, they all spend the same, they just get taxed differently.  Retirees need cash flow from their investments makes a lot more sense to me than retirees need income.

So, the three statements of investment fact that I started with are not factual at all.  Using my definitions, those three statements become categorically false.  I’m not trying to convince you that our definitions are correct (although we believe they are.  See the Bibliography to this article for articles explaining how and why we arrived at our definitions).  My point is to make you aware that other definitions do exist for words that are largely taken for granted.  Your definitions and what you are trying to do may differ from other peoples’ definitions and what they think you are trying do.

So the next time you are talking about stocks ask yourself if you are talking about pieces of paper that are bought and sold every day and whose prices move up and down at random, or if you are talking about the companies you own and how the businesses are performing.  When someone tells you that you cannot take too much risk; are they talking about price fluctuations on your pieces of paper, or are they talking about the probable loss of purchasing power over time?  And when you decide to buy one more mutual fund for “diversification” double check whether you are really hiring someone you believe can manage your investment portfolio, or if you are just adding one more piece of paper to your collection and possibly duplicating what you already own.

The implications are huge.  If you use Muhlenkamp Definitions of these seven terms, you have to conclude that:

Statement 1:  Normally, stocks are safer than bonds. (See our “Climate” essays for our definition of normal.)

Statement 2:  You only need one mutual fund in a diversified portfolio of investments.

Statement 3:  Retirees don’t need income; they need spending money.

Please let us know if we can help you understand our definitions and how they might be useful to you.

*We do agree with the conventional definition of an asset as something you own.

Bibliography

The following essays are on the Muhlenkamp and Company website at www.muhlenkamp.com, or we can mail them to you.

1. “The Inflation Time Bomb

2.  “Defusing the Inflation Time Bomb

3.  “What is Risk?

4.  “What is Risk? Part II

5.  “Diversification – Too Much of a Good Thing

6.  “The Problems with Investing for Income

7.  “Mom, The Squeeze on Your Income will Continue

8.  “Investing and Farming, Know the Climate

9.  “And the Climate Is…

The opinions expressed are those of Tony Muhlenkamp of Muhlenkamp and Company and are not intended to forecast future events, guarantee future results, or offer investment advice.

Published On: June 3rd, 2024Categories: News, Risk

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