I am not immune from the gambling instinct. Many years ago I opened a spreadbetting account and had a go at day trading.

I was thrilled when the blinking lights of the trading platform flashed green, and less so when they turned red – though losing money only doubled my resolve!

And there, in a nutshell, is the gambler’s curse.

Losing money makes you want to go back for more. Las Vegas wasn’t built on the triumphs of its punters, but on the takings of the house. And in the long run, the house nearly always wins.

I learned quickly that day trading was dangerous, and never wavered from my main strategy of methodically investing in passive funds and shares.

My interest in investing is intellectually stimulating, and there are certainly some sunny old days when strong company results come in.

But a laugh a minute it is not.

Day trading for fun and profit

When people discover my interest in investing, they usually respond in one of three ways.

• The most common is complete disinterest, if not mild disdain.

• They may tell me they’ve got some shares in ARM / Google / BP / RBS and they’re a few hundred quid in profit. What should they buy next?

• Or thirdly, they might tell me they once had shares in ARM / Google / BP / RBS, and they lost half their money. Shares are a mug’s game!

I can’t recall anyone gleefully telling me they invested in passive index funds. A few when pushed have admitted they “have some sort of ISA in shares”.

Even when it comes to stock picking, it’s once a year that I meet a stranger who reveals they own a portfolio of carefully selected long-term holdings.

No, for the public, being in shares means punting on prices going up and down.

And while that might be expensive fun (though I suspect filling your hot tub with Cristal and scantily clad Eastern Europeans delivers more bangs for the buck) it’s no way to make money.

Making money can be challenging and stimulating. Rewarding, even.

But the selling point is never that it’s easy or fun.

Get rich slowly? Boring!

Of course we’ve all heard entrepreneurs tell us to “follow our passion” to make our money. When running a business feels like fun, you’re already a winner.

I’m sure that’s true, but even if you’re having fun, you’re still not having it easy.

You might smile as you wake at 6am for another 12-hour day with no promise of a pay cheque, but I guarantee you’ll be doing more than clicking a few buttons for your reward.

What about investing in a tracker fund, or buying your own home? Most people make money through home ownership, after all. And it’s not exactly an arduous ordeal – you get to sleep in your investment every night. No sweat!

But the tricky bit with passive investing or buying a home is the long-term commitment. You’re hunkering down for 20-30 years of sticking to a plan.

There’s also the small matter that you have to earn the money to fund these investments with a job, and that is unlikely to be a rip-roaring affair. The returns from residential property or from a typical run in the stock market will not make you rich unless you put a fair amount of money in first.

Who wouldn’t rather put £1,000 into a day trading account, and duck and dive their way to riches?

Who wouldn’t prefer to have a view, push a button, and “take a position”, as the advert says, rather than pushing crates or taking it from the boss?

Yep, you, me and the rest of us. And when everyone wants to do something that is effortlessly easy to do, then you can be pretty sure that all the profits were long since wrung away.

The horrible business of getting rich

I was discussing all this with a friend who told me she’d invested in a wine fund because it was “more fun” than the tracker fund I’d suggested.

If the wine didn’t go up in value, she could drink it!

True, but another failure of the fun test. Too much fun – so it’s less likely to make her real money.

To give yourself the best shot of making a fortune, you need to do something that nobody else wants to do – and where you’ve also found a way to make an outsized profit. (Few people want to be dustbin men, but that won’t make you rich. Owning a toxic waste dump might).

Here are a few examples.

You could start your own business

Long hours, uncertain rewards, a massive chance of failure, and an almost inconceivable list of things nobody ever tells you about that you’ll have to do every day. Most people cannot be entrepreneurs, let alone successful ones, which is why the few who succeed can make a fortune.

Create you own property empire somewhere skuzzy

Head to a grimy part of Manchester or Birmingham, start buying run down properties, refurbish them with sweat equity, hire some heavies to get your rent collected, and wait 30 years for gentrification to finally roll up at your front doors. High chance of success. Strong chance of having a terrible time.

Invest in unlisted start-ups in boring sectors

The returns from investing in successful private companies dwarf those you’ll make from the stock market. No surprise – it’s much harder to find good ones, they’re very illiquid and even harder to get out of than to get into, and a great many fail. Also the best opportunities will be doing something dull and unsexy, so you won’t want to brag.

It’s worth comparing backing boring unlisted firms with being an angel investor in theatre or films.

Who wouldn’t want to be the patron of a troop of bright young things? To be flattered as you’re asked about a new creative concept, and to go to the opening night to be gushed over by your family and friends?

Too much fun, very little effort – and an extremely high chance of losing all the money you put into it.

Do you feel lucky, punk?

Someone somewhere will back the next Cats or Evita this year. Someone will buy a vintage wine or find the next Damien Hirst at a college art exhibition. Someone will pick up shares in a future Amazon-slayer on the day of its IPO.

Being lucky is the easiest way to get rich (though I suspect it’s actually not the most fun – but that’s an existential conversation for another day).

If you want lottery odds on making your fortune, there’s an easy solution – buy a lottery ticket. For every one person who stares in disbelief as their numbers come up and they make a million, another 20 million crumple and toss their tickets in disgust.

Not exactly great fun, but not too much effort, either. And at £1 a week it’s a hell of a lot cheaper than day trading.

Good reads from around the Web.

I enjoyed Financial Samurai’s post this week about the three worst jobs that made him the leisurely mogul he is today:

Whenever I got yelled at by a client or boss or had to travel thousands of miles for a one hour long meeting, I’d remember back to my high school days and smile.

I had this immense fear that if I did not do well in school, I would end up flipping burgers in the morning, stuffing envelopes in the afternoon, and moving boxes at night for a living.

Thanks to fear, I studied my heart out so I could at least have a chance at a better life.

My own reaction to early wage slavery was slightly different. Two jobs in particular helped make me the mildly maverick man I am.

Key was some part-time temp work I did in a huge office in Central London as a student, processing one privatisation offer or another.

I was going through a left-wing phase at the time, and I don’t remember which issue it was. More importantly, the entire operation was so dispiriting it’s a wonder it didn’t make me a commie.

Every day we’d be assigned near randomly to huge rooms to do different tasks such as sorting envelopes, opening envelopes, or stapling cheques and applications together. Yes, each of these was a different room, and a different role. Mind blowing stuff. ¹

Being mildly obsessive, I took some pride in processing as many envelopes as I could per hour, which my co-workers found hilariously diligent. And they were right, because at the end of the day a swathe of us would be told – arbitrarily, by alphabetical order or similar – that we would not be required the next day, and my time came soon enough.

All my efforts had been completely overlooked by my capitalist masters, and I was cast out like a three-legged donkey.

I vowed that I’d eventually be in charge of my fate. (Also: Better to be a capitalist master than a wage slave).

At least as crucial for me was my several years of delivering newspapers before school. I loved this job, which involved waking at 6am, seeing the bag of papers dwindle to one and then nothing, and “reading” page 3 and the Garfield comic strip before the paper’s legal owners.

My newspaper round felt like a cross between legalized trespassing and paid weight training, as the size of the Sunday supplements grew over the years. Best of all, the wodge of tips I received at Christmas was directly related to my efforts.

I was delighted to read in The Snowball that Warren Buffett also delivered newspapers in his school years.

[continue reading…]

1. And another reason why I’m no fan of sweatshops. Bring on the robots![↩]

One way to try to judge whether the stock market is cheap or expensive is to compare the valuation that investors are putting on companies with the output of the economy.

You can do this by comparing the total stock market capitalisation of a country with its Gross National Product ( GNP).

Stock market cap to GNP ratio = (Stock Market Cap / GNP) x 100

Where:

• Stock market capitalisation = The value of all the companies on a particular stock market.

• GNP / Gross National Product = The market value of all the products and services produced in one year by the labour and property of the residents of a country.

Unlike some technical indicators, this ratio makes logical sense to me.

Individual company earnings – or the earnings of entire sectors such mining or retail –  can be very volatile. That limits the value of using price to earnings ratios to spot bubbles – even if you smooth them by using a cyclical P/E.

However in a developed economy, it seems intuitive that the economic output of a country and the earnings of its companies – and hence their valuation – should bear some sort of relationship.

That’s where this ratio comes in.

Warren Buffett’s favourite ratio

The stock market / GNP ratio means nothing in and of itself – there’s no rule that the ratio should be X or Y at any point in time.

However by comparing today’s ratio with previous readings over time, we can potentially spot episodes of over- or under-valuation.

I say potentially because the ratio is not perfect, as I’ll explain below.

But it was good enough for Warren Buffett in 2001, who wrote:

The ratio has certain limitations in telling you what you need to know.

Still, it is probably the best single measure of where valuations stand at any given moment.

Buffett was using the measure to explain how he saw the Dotcom bubble developing the late 1990s.

The question is can we use the stock market to GNP ratio to spot new bubbles in advance?

Note on GNP versus GDP: Buffett compares the stock market to GNP. Most analysts use Gross Domestic Product (GDP) instead. In theory this should matter a lot. GDP is defined according to location, being the goods and services produced by a country. GNP is defined by ownership, as I’ve explained above. In practice though the two numbers are very close for the US, and the US is the only country where this ratio seems to be regularly computed. So like others, I use GNP and GDP interchangeably below.

History of the stock market to GNP ratio

When you look back in the history books, most stock market peaks in the US have coincided with an elevated level for the stock market to GNP (or GDP) ratio.

And that makes sense. Excessive profitability for companies tends to revert to the mean, and productivity improves slowly.

Advanced economies as a whole grow at low single digit rates, too.

This all means that big run ups in stock prices over short-periods tend to have more to do with investor sentiment than fundamental changes to the long-term prospects of those companies.

In other words, we’re by turns greedy and fearful. Sometimes we’re like footballers’ WAGs in Harvey Nicks, and no price is too high. At other times we’re haggling for cut-price bargains at a boot sale.

By looking at the ratio of stock market to economic output, you can try to spot the ‘greedy’ times and tailor your strategy accordingly.

For example this article and graph from Smart Money used the ratio to suggest that the US stock market had outgrown the US economy:

Smart Money noted that:

U.S. earnings are near a record high as a share of the economy. Over the past 80 or so years that has tended to mean that earnings are about to shrink.

Thus, the chart. If share prices are constrained by earnings, and if earnings are constrained by the size of the economy, investors might as well compare share prices with the economy directly.

Sounds sensible, but with the benefit of hindsight we can see two glaring problems:

• US company earnings didn’t shrink – they kept growing!

• The US stock market rose over 10% in the subsequent 12 months.

If you that graph prompted you to reduce your holdings of US equities and go to cash, you lost money.

Market timing is extraordinarily difficult, and this is just another reminder.

Problems and limitations with the ratio

Wary though I am of disagreeing with Warren Buffett, it seems to me this ratio is no more useful than most other ways of guesstimating whether shares are expensive or not.

It might give the determined active investor some clues, but it isn’t going to solve the mystery.

Let’s consider a few of the problems.

Little UK data for the stock market to GDP/GNP

It shouldn’t be hard to produce UK data, and no doubt various firms do on a private basis. But I can’t find public sources on the Web.

The ratio has only really been looked at in-depth for the US, which limits its usefulness for the rest of us.

Different countries have very different markets

I think it could be misleading to apply this ratio to other countries too superficially, anyway.

For example, one Seeking Alpha writer wondered in 2011 which stock market was the most expensive by this ratio, and produced the following graphic:

The author noted that:

There are several reasons determining the size of a country’s stock market capitalization including, for example, the equity-buying culture of the local population, company use of debt versus equity financing, the country’s regulatory and legal environment as well as how easy it is to list on the local exchange.

In general however, it is probably safe to assume that there should be a positive correlation between a country’s market capitalization and its GDP.

Indeed it turns out there is a very high, 0.96 correlation between the world’s largest economies GDPs and their stock market capitalisations.

I agree with the second paragraph, but I’d question the utility of the third.

The problem is the variations behind that average ratio are so wide. For instance, the author found that at the time of writing, the ratio for Italy was 0.3 and for Germany it was 0.43, whereas for the UK it was 1.5.

Did that mean that Italy or Germany was 4-5 times cheaper than the UK?

I don’t think so.

The UK stock market is home to many companies from around the world. We’re also one of the most capitalistic of the major economies. Our listed market is a bigger deal than the equivalent for Germany or Italy, which are home to far fewer foreign firms and where there are surely more companies in private or even State ownership.

You would need to look at a particular country’s ratio over the long-term to derive any useful insights into its market valuation versus economic output at any particular time.

And comparing one country’s ratio with another seems entirely spurious.

What about overseas sales?

This is an important factor, which most of the articles I’ve cited also mention.

Apple, Google, and many other big US companies earn much of their money overseas. This means that comparing their valuations with US economic output could be misleading. Why should they be limited by US growth?

Of course, global trade is nothing new. I don’t know off-hand how the proportion of earnings generated by US companies overseas has changed over the years.

I know it has changed, though, and it is another factor to consider.

The ratio is often elevated, and thus arguably useless

The biggie. Look at the graph from Smart Money again. The red line is mainly above the blue line, which means the US market has most often tended to look overvalued.

History may yet prove this to be the case, but over long multi-year periods it’s been a pretty poor signal to get out of stocks.

The ratio is even more stretched if you go back to the 1950s:

(Source: Vector Grader)

This is a really interesting graph, because it suggests the US market might have been very over-valued for a couple of decades.

I have previously explained why I think carefully looking at long-term returns suggests that ain’t necessarily so.

Which view is right? Who knows – history is unfolding before our eyes. My best guess is the answer lies somewhere in the middle.

Clearly the US market was a steal in the 1950s and 1960s (when Warren Buffett started getting rich, incidentally). This was when the ‘Cult of the Equity’ was born, and investors began to shift wholesale from bonds to equities.

However I think globalisation and various other factors have probably changed the ‘fair value’ level for the ratio since the 1950s.

In addition, with interest rates very low – and fears of inflation not abated – it is arguably rational for investors to pay more for the earnings of companies today.

You’ll have to make your own mind up. As always, I certainly wouldn’t use this ratio in isolation from other factors.

Remember, most methods of predicting the returns from equities have a truly dire track record. Be warned!