A fundamental lesson of business school is that the best kind of financing is free financing using OPM — Other People’s Money.
You see this all the time in business. A developer borrows millions to put a new building but not a cent of his own cash flow. A startup pays its employees in stock rather than cash.
When it comes to investing, OPM is as simple as using index funds.
How so? Consider what a “normal” investor is doing day in and day out. He or she is buying stocks, sure. To do that, there’s a certain amount of effort involved.
You have to research the stock or buy someone else’s research. That’s time and money down the drain.
Then you have to actually buy the stock, which means you will pay a commission for the trade. Multiply that by a few dozen stocks, buying and selling week in and week out, and soon you’re talking about real money.
Perhaps you get one of your stock picks wrong and it drops far more than you are comfortable with. So you sell and take the loss. More money gone, plus another commission.
The active investor is doing something else, however. He or she is creating liquidity in the market. By arguing over the right price through trading, the market magically sets a number that anyone else can trust as being the right price — at least at that moment.
Multiplied through thousands of trades, the volume of buying and selling tends to cancel out extremes and creates a fairly steady price over time.
For any given stock, of course, that price can fall and maybe not recover for years. Or it might zoom higher and stay aloft for years.
As the passive index fund investor, you get to ride along on all of that price action at an extremely low cost. You don’t really have to learn the hard way the true value of a single stock because you own them all.
Other people’s money is hard at work setting those prices. Over time stock prices rise, according to long-term studies by academics such as Jeremy Siegel and Robert Shiller.
Why? Siegel puts it down to corporate pressure on managers to grow the value of a firm in excess of inflation, which makes sense since not doing so is a sure road to bankruptcy.
Secondly, Siegel points out that dividends are typically reinvested. That’s more money pouring back into the hands of the investor from the efforts of others.
Dividends are not quite OPA, but close. It’s your money as a shareholder, but you don’t have to make any particular effort to earn it, just hold the stock.
Finally, there’s compounding, the way that reinvested dividends and capital appreciation feed back to double your money, then double it again and again. Yes, it’s your money, but it’s growing because a lot of other people are helping you by shouldering the cost of investing.
OPM is a great investment strategy, one that any business school dean would admire. All you have to do to take advantage of it is own low-cost, index-style investments, reinvest dividends and be patient.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.