In this article I will discuss the differences between Investment and Speculation from the Wizards of Stock Markets like Ben Graham, Warren Buffett, Jesse Livermore, Sanjoy Bhattacharyya and others. Around 3 weeks back, Shri Narendra Modi, our Prime Minister announced a sudden demonetization of Rs 1000 and Rs 500 notes (currency-swap) in India, and since then the stock markets have crashed significantly, and some stocks have gone down by as much as 30%. Ideally markets like these should be the right time to buy – as good companies are available cheap and provide excellent investment opportunities (I bought a few, I’ll admit). But before putting your money into stocks, it would be prudent to review the difference between investment and speculation.
Common Sense view of Investing
Investment is the sacrifice of current rupee for future rupee, and has two components – time and risk. The outflow of money is now and certain. The inflow if at all, its size and timing are all uncertain. For example, when amount, time and inflow are known in advance, it is like a fixed deposit. On the other extreme, only the outflow is known in the case of stocks, and inflows (dividends and capital appreciation) have to be estimated. Investments may be made in real assets or financial assets through either primary markets or secondary markets. (10)
Warren Buffet offers the following definition : “Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.” (2)
The Components of Investing
Benjamin Graham, the Father of Value Investing, defines investment as follows : “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting this requirement are speculative.” (1)
He goes on to explain each component of the definition:
– Thorough Analysis means “the study of facts in the light of established standards of safety and value”
– Safety of Principal means “protection against loss under all normal or reasonably likely conditions or variations”
– Adequate returns refers to “any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence”
Speculation is …
In other words, an operation where there is a lack of even one of the above is speculation. No analysis, means speculation. No surety on safety of principal is speculation. No promises of adequate return is also speculation.
Jesse Livermore, the 20th century’s speculator provides his own definition of speculation. He says: “The speculator is not an investor. His object is not to secure a steady return on his money at a good rate of interest, but to profit by either a rise or a fall in the price of whatever he may be speculating in.” (7)
According to legendary investor Philip Carret , those who focus on underlying economics of the business are investors while those who focus on the price are speculators. “Speculation may be defined as the purchase or sale of securities or commodities in expectation of profiting by fluctuations in their prices.” He gives an example: “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.”(12)
In the 17th century, Joseph de la Vega while writing on the stock market business observed three classes of men:
The princes of business, called “financial lords,” were the wealthy investors the merchants, the occasional speculators, were the second class the last class was called the “persistent speculators” or the “gamblers” (11)
Confusion between Investing and Speculation
Ben Graham explains further: “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… 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.” (11)
Graham said this 80 years ago in an America context. This is such a beautiful observation and is applicable even today after 80 years in an Indian context. The TV Channels are flooded with experts, and commentators forecasting and providing new trends, worrying about next quarter results, and contradicting each other, and making one prediction after another. The only people who suffer are the small investors who have been lead to believe that analysis and longer term investments are for the foolish people.
Lord Keynes, the father of modern economics, had a very good analogy for the stock market. In the words of investment mahaguru Sanjoy Bhattacharyya:
“Lord Keynes famously compared stock exchanges to a beauty contest. In his view, the trick was not to identify the most beautiful face but rather guess which one the other judges would find most appealing. Two approaches to investing follow from this metaphor. First–speculation–which requires deep study of the current fads and prevailing fashions that hold sway over other participants. Second–owning a valuable business–which needs a detailed understanding of what an enterprise stands for relative to its current worth.” (13) As is evident, the first approach is speculation while the second approach is investment. Lord Keynes says as such – “speculation relies on “accurate forecasting whereas investing is driven by top-drawer business analysis and a keen understanding of what creates economic value over the long term.”
Gambling, Speculation and Investing
Peter Lynch defines investment as “simply a gamble in which you’ve managed to tilt the odds in your favor.” (3) Note the use of the word “gamble” in the definition of investment.
Benjamin Graham in fact agrees that at times the division between investment and speculation is not always very strict. He says: “Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss and the risks therein must be assumed by someone.” (8)
Seth Klarman of Boston based Baupost Fund believes that investment is infact an arrogant act. An investor who buys is effectively saying that he or she knows more than the seller and the same or more than prospective buyers. This necessary arrogance must be countered with an offsetting dose of humility by always asking whether one has an apparent advantage over other market participants in any potential investment. (9)
Ben Garaham focusing on the difference between intelligent investing and intelligent speculation says: “There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are:
- speculating when you think you are investing
- speculating seriously when you lack proper knowledge and skill for it
- risking more money in speculation than you can afford to lose.” (8)
Risk, Return and IQ
Many people suffer from the misconception that that trying to make serious money requires that one take serious risks or that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. In fact, the converse is true. Avoiding serious loss is a precondition for sustaining a high compound rate of growth(4).
Moreover the rate of return should be dependent on the amount of intelligent effort the investor is willing and able to bring to bear upon his task. Warren Buffet has the following to say: “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”(5)
Similarly also, intelligent speculation requires hard-work. Jesse Livermore says: “The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor … Speculation is a hard and trying business, and a speculator must be on the job all the time or he’ll soon have no job to be on.”
As per Peter Lynch , “Investing is an art, not a science, and people who have been trained to rigidly quantify everything have a big disadvantage”.(6)
(1) Benjamin Graham, The Intelligent Investor, Investment versus Speculation: Results to be expected by the Intelligent Investor, 18
(2) Warren Buffet, 2012 letter
(3) Peter Lynch, One up on Wall Street, p. 74
(4) Benjamin Graham, David L. Dodd, Security Analysis, 2009, Pg 40
(5) Benjamin Graham, The Intelligent Investor: Preface to the Fourth Edition, by Warren E. Buffet, ix
(6) Peter Lynch, One up on Wall Street, p. 74
(7) Jesse Livermore, Reminiscences of a Stock Operator
(8) Benjamin Graham, Intelligent Investor
(9) Seth Klarman, Letter to Baupost Fund Shareholder (1996)
(10) William Sharpe, Gordon Alexander and Jefferey Bailey: Investments
(11) What Is the Difference between Investing and Speculation?
(12) Philip Carret, The Art of Speculation
(13) In Praise of Lord Keynes
Speculation Defined – Graham and Dodd’s Definition of Speculation
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A Few Last Words
Before making any investment decision, please contact your financial adviser.
I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. I do not offer any opinion concerning securities or public offers. Whatever analysis I provide is through public media only on Mkerj. I am not covered under RA Regulations.
I have provided this article for educational purpose only.
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