Lesson #2: Are You an Investor or Speculator?

Value Investing Masterclass - Safal NiveshakA lot of investors I meet or interact with through Safal Niveshak want to seek my opinion on their stock portfolios – a large number of them being in complete mess.

One big reason for the same is the fact that most of these people bought stocks without a hint of what they were getting into. It’s like they were flirting with someone and then saying they were serious all this while! 🙂

I still remember this small conversation with a friend sometime in October 2008. This gentleman, my classmate from school, had been a bright student in the past. He was a practicing doctor, but had no clue about investing in the stock markets.

But one fine day, on advice from some of his patients (yes, even patients can give doctors some ‘painful’ advice!), took his first step into the stock markets only to see his savings burn in the crash that followed.

Sometimes I wonder how even intelligent people (like my doctor friend) fall into the trap of playing with their hard-earned money without knowing what they are getting into.

They work so hard for many years to become successful students, professionals, and businessmen. And then, in a small phase of mindlessness, lose their entire savings just because ‘someone’ advised them a way to become rich fast.

Most of such people I have had the luck to meet call what they are doing as ‘investing’.

If the father of investing – or let me say ‘sensible investing’ – Benjamin Graham were to hear that, he’d turned over in his grave!

Graham was among the firsts to clearly define what ‘investing’ actually is, and how it differs from what most people do in the stock markets (like my friend did) i.e., speculate.

But before I take you to Graham’s definition of investing and speculation, let me take you a bit deeper into their entire confusion most people have between ‘speculation’ and ‘investing’.

Let me first ask you – What do “you” think is the difference between investing and speculation?

At first, you think the answer is simple because the distinction is obvious, especially after you may have already read Graham’s definition and so many posts on Safal Niveshak.

But still, put pen to paper and try to answer the question – “What is the difference between investing and speculation?”

Go ahead. Take a few minutes and think about it. First write down the definition of “investing.” Then do the same for “speculation.”

If you are like me, frustration quickly builds because the answers do not come quickly or easily, and they should.

After all, these terms have been a part of the financial jargon ever since Joseph de la Vega wrote Confusion of Confusions in 1688, the oldest book ever written on the stock exchange business.

In this book, de la Vega observed three classes of men:

  1. The princes of business, called “financial lords,” were the wealthy investors.
  2. The merchants, the occasional speculators, were the second class.
  3. The last class was called the “persistent speculators” or the “gamblers.”

Then, around 250 years later, Philip Carret wrote a book called The Art of Speculation where he believed that the best way to determine the difference between investment and speculation was the “motive” of the person involved.

As he wrote…

The man who bought United States Steel at 60 in 1915 in anticipation of selling at a profit is a speculator. On the other hand, the gentleman who bought American Telephone at 95 in 1921 to enjoy the dividend return of better than 8% is an investor.

In simpler words, Carret suggested that while an investor is concerned about the fundamental economics of the business, the speculator is worried just about the stock price.

He wrote, “Speculation may be defined as the purchase or sale of securities or commodities in expectation of profiting by fluctuations in their prices.”

Sound eerily similar to what you have seen people around you doing? Or like you yourself have done over the years? 🙂

Anyways, let’s now come to Benjamin Graham who differentiated between investing and speculation in the 1934 edition of his “Bible of Value Investing” called Security Analysis.

Graham defined…

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

However, when he came out with his The Intelligent Investor in 1949, Graham confessed…

While we have clung tenaciously to this definition, it is worthwhile noting the radical changes that have occurred in the use of the term ‘investor’ during this period.

Effectively, Graham was concerned that the term “investor” was now (in 1940s) being applied universally to anyone and everyone who was “in” the stock market.

He said in an interview…

The newspaper employed the word ‘investor’ in these instances because, in the easy language of Wall Street, everyone who buys or sells a security has become an investor, regardless of what he buys, or for what purpose, or at what price, or whether for cash or on margin.

He then concluded…

Since there is no single definition of investment in general acceptance, authorities have the right to define it pretty much as they please. Many of them deny that there is any useful or dependable difference between the concepts of investment and of speculation. We think this skepticism is unnecessary and harmful. It is injurious because it lends encouragement to the innate leaning of many people toward the excitement and hazards of stock-market speculation.

So, even Graham did not leave us finally with a clear distinction between investing and speculation.

It is the same point that was mentioned by another legendary investor John Bogle who, in The Clash of the Cultures: Investment vs. Speculation, argued that in the minds of most individuals, investment and speculation are now indistinguishable.

But he opined that “investment means long-term ownership” whereas “speculation is more short-term trading”.

So here we are with three different versions of the distinction between investing and speculation…

  1. Carret distinguished on the basis of the focus of the investor – business or stock price
  2. Graham said it was mainly on account of how and why things were bought – thorough analysis, safety of capital
  3. Bogle stressed upon time horizon – short term versus long term

Let me now bring in Seth Klarman, who wrote in Margin of Safety

…assets and securities can often be characterized as either investments or speculations. The distinction is not clear to most people. Both investments and speculations can be bought and sold. Both typically fluctuate in price and can thus appear to generate investment returns. But there is one crucial difference: investments throw off cash flow for the benefit of the owners; speculations do not. The return to the owners of speculations depends exclusively on the vagaries of the resale market.

Finally, here’s what Warren Buffett says…

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Buffett adds…

Basically, it’s subjective, but in investment attitude you look at the asset itself to produce the return. So if I buy a farm and I expect it to produce $80 an acre for me in terms of its revenue from corn, soybeans etc. and it cost me $600. I’m looking at the return from the farm itself. I’m not looking at the price of the farm every day or every week or every year. On the other hand if I buy a stock and I hope it goes up next week, to me that’s pure speculation.

Of Silly Charts and Voodoo Practices

John Maynard Keynes defined “speculation” as “…the activity of forecasting the psychology of the market.”

He said that the speculator must think about what others are thinking about stocks and the stock market.

In Chapter 12 of his book – The General Theory of Employment, Interest and Money (1936) – where he explained price fluctuations in equity markets, Keynes wrote…

It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

So, in a Keynesian beauty contest, the judges are told not to pick the most beautiful woman (the best business) but instead to pick the contestant they think the other judges will choose as the most beautiful (the most speculative stocks). The winner of such a contest may be very different than the winner of a traditional beauty contest.

Much of what you see during IPO rush and bull markets is in fact a Keynesian Beauty contest, with stock market participants trying to guess what others are thinking…about what others are thinking…about what others are thinking [repeat].

So, effectively, people who indulge in day-trading or swing-trading using silly charts and other voodoo-like practices are speculators.

You will hear them talk about how the market “behaves” rather than what the value of a given stock may be. But then, to guess about market “behavior” based on a chart is just that – a guess!

In a 2011 interview, Buffett was asked to explain how he sees speculation as opposed to investing. Buffett replied…

You know, it’s like pornography… the famous quote and all that. I look at it in terms of the intent of the person engaging in the transaction.

…An investment operation in my view is one where you look at the asset itself to determine your decision to lay our some money now to get some more money back later on. So you look to the apartment, house, you look to the stock, you look to the fame in terms of what that will produce. And you don’t really care whether there’s a quote under it at all. You are basically committing some funds now to get more funds later on therough the operation of the asset.

Speculation, I would define, as much more focused on the price action of the stock, particularly that you buy or the indexed future or something of the sort. Because you are not really, you are counting on, for whatever factors, could be quarterly earnings, could be up or it’s going to split or whatever it may be or increase the dividend, but you are not looking to the asset itself.

And I say the real test of how you, what you’re doing is whether you care whether the markets are open. When I buy a stock, I don’t care whether they close the stock market tomorrow or for a couple of years… Now if I care whether the stock market is open tomorrow then I say to some extent I’m speculating because I’m thinking about whether the price is going to go up tomorrow or now.

And then gambling I would define as engaging in a transaction which doesn’t need to be part of the system…

What Do You “Want”?

Just think for a moment, and you are not embarrassed to admit that you want your investments to support you during your years in retirement. Neither are you embarrassed to admit that you want your investments to support your children or help you do good work for others.

But then, if you are like most investors out there, some of what you want from your investments is embarrassing, such as your wanting status.

You might want to mention your investment in the “best” or the “hottest” stock out there, as you think it signals high status.

I have seen a lot of investors buying expensive stocks just because they couldn’t have avoided not owning these stocks like other “successful” investors who made money in them.

It may be due to jealousy of seeing others make money, or regret of missing out on future returns, but look around and you would find even serious investors speculating to make a quick buck ‘just one last time’!

But then, a loud expression of your “investment status” (like “I have bought a great stock like Titan” or “I bought Nestle”), like a loud display of an oversized logo on a Louis Vuitton bag, can bring embarrassment rather than an acknowledgment of status.

In a 1930 book, Watch Your Margin: An Insider Looks at Wall Street, the author asks a person – “Do you know why people go into stock speculation?”

“To make money,” the person replies.

“Not at all,” says the author, “They go in for the pleasure of getting something for nothing. What they want is a thrill. That is why we drink bootleg whisky, and kiss the girls, and take new jobs. We want thrills. It’s perfectly human, but Wall Street is a poor place to look for thrills, for the simple reason that thrills in Wall Street are very expensive.”

The world has changed greatly since then, but our wants remain the same. The man answering the author above (that we speculate to make money) is not entirely wrong. We do want to make money from investing and speculating.

But the author is surely right. We want pleasure from investing and speculating, and we want thrills from playing the beat-the-market game and winning it.

The truth is that the stock market is still a dangerous place to look for thrills and the stock market thrills remain expensive, but we are willing to pay the price.

In fact, a majority of participants in the stock market consider themselves like sportsmen. They want to win.

In sports, only if you win the gold medal are you paid millions for endorsements of shoes, watches, and cereals, while silver and bronze-medalists are paid little, and fourth-place athletes are paid nothing. Gold medals also bring the emotional benefits of pride and the expressive benefits of a winner’s image.

It is no wonder that an Internet broker made the connection between investment competitions and sport competitions in an advertisement displaying a sprinter in starting blocks above a caption…

If you’re waiting for just the right time to start investing online, we have one thing to say. Bang!

You see, the race to speculate in stocks to earn big money, and do that quickly, is too tempting…and the desire to win is too strong.

But the consequences are sad! You already know it, don’t you?

Finally, Mark Twain said that there are two times in a man’s life when he should not speculate: when he can’t afford it and when he can. Because this is so, understanding the difference between investment and speculation is the first step in achieving investment success.

And that’s exactly what we will try to do now.

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