Investment v/s Speculation
Most buyers and sellers in the stock market, don’t know whether they are investing or speculating. Everyone who buys and sells a stock has become an investor, irrespective of what he stocks he buys, or for what purpose, or at what price, or whether for cash or on margin.
Investing and speculating are two separate activities, but the term investor is commonly used for everybody in the stock market.
INVESTMENT
Benjamin Graham, the father of value investing, defined investing as :
“An investment operation is one which, upon thorough analysis promises the safety of principal and an adequate return. Operation not meeting these requirements are speculative.”
Investment Operation: Investing requires adequate efforts in terms of research and understanding the investment option available, determining their suitability for the needs of the investors and their appropriate value. Investing is not a one-time activity, but one that requires regular tracking, monitoring and suitable changes to the investment decisions based on new set of information and understanding. The activities associated with investments must be undertaken in a disciplined and systematic way.
Warren Buffett, once said, “Investing is most intelligent when it is businesslike.”
Thorough Analysis: Buying shares of a company is equivalent to taking part ownership in a business. Indeed, buying a business (fully or partly) is alternative to starting a business and would demand same kind of research and analysis as would be required when considering to start a business on various dimensions of the business-like products, customers, inputs, outputs, competition, regulatory environment, potential opportunities, threats, etc.
Safety of Investment: According to Benjamin Graham, the first objective in investing has to be to protect the investment value, so it is important to identify opportunities that provide a margin of safety. It means buying stocks that are trading at a significant discount to its underlying value. Backed by strong research and monitoring, an investment portfolio should be able to protect the investor’s investment value over a suitable investment horizon, despite short-term fluctuations in the market.
Adequate Return: While the meaning of adequate is not defined by Graham, it would probably mean risk-adjusted return in comparison to other competing avenues for invested capital. It is important to understand the risk and return features of an investment before committing to it.
Investors that follow the above tenets are said to be engaged in investing.
SPECULATION
Speculation is short-term calls made with leveraged funds, unlike investing money which is a long-term disciplined activity for creating wealth. Investing money without understanding and analyzing the investment options, their risk and return features, and appropriate value would be like taking a bet or speculating rather than investing.
Benjamin Graham wrote in his book, The Intelligent Investor that, There is intelligent speculation as there is intelligent investing.
Speculation is beneficial on two levels:
- Without speculation, untested young companies would never be able to raise the necessary capital for expansion.
- Speculation helps in, providing liquidity in the market. Risk is exchanged every time a stock is bought or sold, but it is not eliminated. The buyer purchases the primary risk that this stock may fall. Meanwhile, the seller still retains a residual risk- the chance that the stock he sold may go up.
***But there are many ways in which speculation may be stupid.
- Speculating when you think you are investing
If you are investing based on the tips from so-called market experts, friends, colleagues or buying a stock just because it has gone up recently, then you are not investing, but speculating.
Investing in stocks requires skill and rigorous analysis, so you must never fool yourself into thinking that you’re investing when you are actually speculating.
- Speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it
Speculation is always fascinating, and it can be a lot of fun as long as you are ahead of the game. If you want to try your luck at speculation then put aside a portion, the smaller the better, of your capital in a separate fund for this purpose. You may call it Mad money account, Sin Money account or whatever you may like to call it. But never add more money to this account just because the market has gone up and the profits are rolling in. Actually, that is the time to think of taking money out of your speculative fund. Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.
Speculation in itself is risky, and if you do it without proper skill and knowledge, it can be dangerous. It becomes dangerous the moment you begin to take it seriously.
- Risking more money in speculation than you can afford to lose.
It is very common to bring a great deal of energy, study, and native ability into the stock market and to end up with losses instead of profits. So, when can you lose money in the stock market, after putting a lot of effort, hard work, and extensive research? It is very easy to lose money in an activity like speculation, where you don’t put in that kind of hard work and rigorous analysis.
So, you must put strict limits on the amount you are willing to wager. To be precise, one should not put more than 10% of his capital in the speculative fund. Never mingle the money in your speculative account with what’s in your investment accounts, never allow your speculative thinking to spill over into your investing activities, and never ever put more than 10% of your assets in your speculative account.
Personally, I don’t speculate. Why?
Let me take the help of Warren Buffett to answer that. In his words, “Speculation, in which the focus is not on what an asset will produce but rather on what the next fellow will pay for. It is neither illegal nor immoral. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?”
I neither have trading skills nor the interest to develop those skills. And most important it’s not the game I wish to play. I believe my skill set is analyzing the fundamentals of the company and exploiting discrepancies between price and value. This is a game I like to play, hence I am a value investor.
Who are You? Investor Or Speculator?
Buffett said that the line which separates investment and speculation is never bright and clear, moreover, it gets even blurred when most market participants have recently enjoyed triumphs.
Since the line that separates investment and speculation is very thin, one can easily fool himself thinking that he is investing, while he is actually speculating.
And that line gets even blurred during a bull market, because, when the stocks are rising every day, it is tough, even to the sensible person, not to speculate. They know that speculating in stock with gigantic valuations relative to its intrinsic value will result in permanent loss of capital, but they hate to miss even a single minute of that party. They plan to leave just seconds before midnight. But the problem is, they are dancing in a room in which the clocks have no hands.
Their recent success in the stock market will get to their head, which makes them over-confident, they think that they can predict the top of the bubble, but in the end, the market falls like a pack of cards, hurting all the greedy and highly leveraged speculators.
“Mark Twain said that there are two times in man’s life when he should not speculate :
when he can’t afford it and when he can afford it“
The first step in achieving investment success is in understanding the difference between investment and speculation.
Speculators, buy and sell theirs based on whether they believe those stocks will next rise or fall in price. Their judgment on future price movements are not based on fundamentals of the business but based on their prediction of others behavior. They are basically ignorant of investment fundamentals.Whereas,
To investors, stocks represent part ownership in the business. Investors buy and sell based on comparing share price to its intrinsic value. They buy cheap and sell dear. They believe that stocks do well or poorly in the future because the businesses behind them do well or poorly, nothing more, and nothing less.
Investors believe that over the long run stocks prices tend to reflect fundamental developments involving the underlying business. So they expect to profit in at least one of the three possible ways:
- From free cash flow generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends.
- From an increase in the multiple that investors are willing to pay the underlying business, which eventually will be reflected in a higher share price.
- By narrowing the gap between share price and underlying business value.
Investing demands hard work – The activities involved in investing require a large commitment of time and effort, along with the skills and understanding to collect relevant data, analyze the investment options, execute the decisions and monitor the portfolio. Most investors may find that they fall short on these demands. Making investment decisions without the necessary skills would mean that the investor’s money is not being deployed in the best way possible.
Become a skilled investor or hire someone to manage money – Investors can either develop the skills required to make and manage their investments or find someone with the qualification who they can trust to do so. Investors should never forget to do thorough diligence on the money manager. They should focus on aspects such as qualifications, experience, performance track record, systems, and support facilities, integrity, philosophy of investing and other relevant factors of the managers.