Speculating in the financial markets is a matter of choice. But undoubtedly, speculating without knowing it, is a likely recipe for financial disaster. Read on to understand whether you are ‘actually’ investing.
Anyone who participates in the financial markets is invariably advised to ‘invest’ rather than ‘speculate’ for long term success. But do we really understand the distinction between these two terms? Many investors don’t and consequently remain under the false impression of investing when they are actually speculating.
Before defining the distinction between ‘investing’ and ‘speculation’, let’s try and understanding why is this distinction important in the first place.
Do we even know whether we are investing or speculating?
Can you treat a disease until you know you have it? Well, it’s the same with investing and speculating – you cannot do justice to either until you understand what you are doing. Moreover, the most risk in financial markets emanates from not knowing what you are doing.
Whether investing is better than speculation or vice versa is a matter of another debate. In this post we shall only concentrate on the distinction between the two so that you do not have a wrong impression about your activities associated with the stock market i.e. Think you are investing while you are actually speculating (and vice versa).
Secondly, knowing the difference between investing and speculation prepares you to better handle the fluctuations of the financial markets. Markets can often be out of sync with underlying fundamentals and it is at those very moments that ‘investors’ are able to keep their emotions in check and not get swayed by public opinion. Even intelligent speculators are able to place important checks in place to minimize the risk of financial catastrophe. In all financial meltdowns, the only people who end up suffering are the gullible public who join in because everyone else seems to be making money.
Finally, your choice of the companies depends on whether you are investing or speculating. Investing requires that you think hard before you add any company in your portfolio. In such a scenario, you are more likely to choose fundamentally good companies and base their decisions on facts rather than cocktail party tips.
Now to the distinction between Investing and Speculation
Benjamin Graham, in his seminal book, ‘Security Analysis’ defines an investment operation as one which,
“upon thorough analysis, promises safety of principal and a satisfactory return“.
Everything else, he says, is speculation.
As simple as it seems, this definition contains some of the most profound words in the world of stock market investing. The definition is built around 3 key pillars:
- thorough analysis,
- safety of principal; and
- a satisfactory return.
Thorough Analysis: Analysis means making a careful study of facts in order to arrive at conclusions of whether to invest in a particular company or not. In other words, the purpose of an analysis is to gain information about a company which would enable you to make certain judgments as to its attractiveness or otherwise as an investment. For instance, careful analysis would involve a thorough study of a company’s financials (including key financial ratios), its management, business model, etc. Further, this analysis has to benchmarked against specific standards and principles.
Safety of Principal: The word ‘promise’ signifies that under normal conditions, an investment is something which gives you a reasonable assurance that an investor’s capital will be protected (note the use of the word ‘promise’ instead of ‘guarantee’). For instance, you find a company which is trading in the stock market for less than its net-cash position, i.e. cash after paying of all the liabilities. As you can intuitively understand, a purchase of stock at such a price reasonably assures you of the fact that risk of loss is minimal.
Satisfactory Return: A satisfactory return is a return, howsoever low, that an investor is willing to accept for taking on the additional risk of investing in equity shares of a company. The one striking feature of the definition is that safety of principal precedes return. Investors are generally more concerned with protecting their capital rather than generating exceptional returns.
Now, if we tell you that the above is a guarantee for stock market success….
Well, don’t believe us (or anyone else who says this). Investing is uncertain and even the best of analysis cannot guarantee success. Whether an investment makes money or not can be known only once the transaction has been completed. If one was to equate “investment” with only profit-making transactions then, all speculations that result in a profit would also be classified under the category of investments. Therefore, as Graham says, the term investing in such a case would be reduced to mere successful speculation.
So, instead of focusing on making the most profitable trades, focus on the above characteristics to minimise your errors (even BIG mistakes). And as Charlie Munger, the billionaire business partner of Warren Buffett says,
“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
The above definition of investment should hold you in good stead whenever you are in doubt of whether a particular action is an investment or a speculation. In our next post, we shall be dealing with some common misconceptions about what constitutes an investment and what constitutes speculation.
PS: I would like to humbly submit that I can never do full justice to explaining Graham’s insight. So, for someone willing to put in the effort, it is advisable to read Security Analysis and understand the definition in Graham’s own immortal words.