Something for Nothing

As I have been thinking and reading about the credit crisis my mind has been chewing on the idea that there are two very different kinds of investing. One is the kind of investing where you put in an initial outlay of resources and follow that with efforts to improve the investment (whether that is a company, an idea, or a building) so that the final product is greater than the sum invested and thus turns a profit. Some examples are finding a company in need of cash with a good idea, a business plan, and the support of other qualified investors and giving them cash to help realize their plans and turn a profit. Another example is buying a distressed property and fixing it up. Perhaps you are purchasing a house for $150,000 in an area where most houses are going for $225,000. You put in an extra $70,000 in materials and time to get the house in prime shape and then sell it for $240,000 – realizing $20,000 profit for your efforts.

The second kind of investing is the shortcut based on the mentality of seeking something for nothing – it’s called speculating. Although it may look similar to traditional investing it is really just a serious form of gambling. An example of this would be buying into a company that is cutting corners to turn a profit and operating with a loose regard for the rules of their business. They put on a good show with richly rewarded executives and a lot of talk, but there is no substance to their ideas if you do a little digging. Another example would be "flipping" a house. You go in and buy a house with an interest-only mortgage where the owner is in a hurry to sell and then you turn around and sell the house at a $100,000 profit within weeks without putting in any work. It also applies to those who purchase a large, showy home (compared to what their income should support) with an adjustable rate mortgage on the assumption that the value of the home will rise in time to refinance the home later using the "equity" gained by sitting in the home for a year – worse is when they intend not only to refinance, but to refinance and get cash out to support a lifestyle that they cannot support on their regular income.

A financial crisis, at least for individual cases, may result from either approach to investing – but it is much more likely (and I believe it is generally more damaging) when the crisis results from speculating. I am convinced that every time we experience a bubble in the economy – whether it’s a tech bubble, a housing bubble, or any thing else – the bubble is a result of speculation, even though there is legitimate investing taking place as well. In our current credit crunch we will not be able completely sort out those who were burned by speculating and those who were legitimately investing (the same is true anytime a bubble bursts) so we must either rescue some or all of those who were speculating, or else we will have to accept in advance that many people who did nothing wrong will be paying the price for the fallout from the rampant speculation that caused the crisis.