Am I Investing Or Speculating…?

Am I Investing or Speculating...

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

Benjamin Graham

The year was 2008, I was 25 years old at a Thanksgiving dinner with some family and friends. If you remember 2008 was the year the “Great Recession” took hold of the market and everyone started paying attention to the stock market. It was a very scary time and we were very close to going over the cliff in many respects.

I had just been promoted to portfolio manager at a small investment fund, and because of my mother, everyone at the dinner knew it too — thanks mom. This meant I was the one taking questions all day.

One person in particular caught my attention though. Little did I know it at the time, but it was a day I will never forget.

Uncle Howie was a fun loving guy. He went about his business and always tried to do the right things in life.

Howie was like the majority of Americans, Howie had some money socked away in his 401(k) and IRA from years of saving, and he even invested in individual securities from time to time.

I could tell by his hesitancy as he approached, that he was scared!!! He asked if we could speak in private, so we quietly escaped the party and we went outside where we could talk. As he sat down across from me, I could see thee white in his eyes.

He was frightened even more than I had imagined. He said "everything was great up until a year ago and his life savings were now cut in half. He didn’t know what to do."

Before he could finish his next sentence, he started gasping for air and looked stone cold white. This very conversation triggered a panic attack, so I helped him get his breathing under control sat him back down calmly and said, “I’m not leaving here till we figure this out.”

Uncle Howie wasn’t the only person going through these physical, mental, and emotional issues.

Many do not understand the difference between investment and speculation but it’s a BIG DIFFERENCE. And it can be cause for big concern if you don’t understand who you as a person when you put money in the stock market (or anywhere for that matter).

Let me be clear: This not a shot across the bow of the trader or speculator. I am not here to berate speculation or declare investing sacred. Speculators and investors each serve very important roles in our marketplace. They both need each other for a market to work properly.

It’s an interesting symbiotic relationship, but understanding the difference between investment and speculation will make all the difference in the world in how you will make decisions to grow your wealth over time.

Essentially, investors are those that invest in things with little risk of permanent capital loss and expected return in the future. As is the case today, many refer to themselves and others as investors when the fact is — they’re really speculators. The most common occurrence of this is in the media.

You’ll hear someone come on T.V. say they are invested in Coca-Cola today — only to find out tomorrow they sold their position an hour after stating it on the air. There’s nothing wrong with it, but that’s speculating folks — not investing.

This is an everyday occurrence and it’s perfectly fine for those that wish to make those decisions. Everyone is free to buy and sell whatever they wish. The only issue is making sure we understand the difference between investing and speculating. Only then will we be able to understand our emotional pain points and make decisions correctly in the face of emotion or fear.

This goes beyond mere semantics. The distinction between investor and speculator is a philosophy which helps plant the seeds to your future success. If an investor does his/her homework correctly, they need not worry about market volatility like speculators or traders.

In fact, this volatility usually provides opportunity to the patient, long-term investor because they’ve already invested in a security with minimal risk and an expected return. As an investor, market volatility to the downside helps to decrease your risk and increase your expected rate of return (all else being equal).

"The stock market is filled with individuals who know the price of everything, but the value of nothing."
Phillip Fischer

For example, many of the participants of the tech bubble leading up to 2000 were speculators hoping the price of various securities would increase in price. Had they been investors, they would have seen that the euphoric stock prices were not justified by the underlying fundamentals of the businesses.

To a large extent, investors did not allow these businesses to become a big part of their overall portfolios. As a result, they were not hurt as badly as speculators when prices eventually turned for the worse to come more in line with the underlying fundamentals of the businesses.

Of course, this doesn’t mean speculation should be avoided all the time. It just means, as an investor, you should keep it as a small percentage of your overall portfolio (less than 10%). Remember, without speculation, how would new or potentially life changing companies raise capital. Speculation carries with it interesting virtues if done in a smart, risk-averse manner.

There are three things an investor must do to be successful:

1. Carefully analyze a business and the reliability of its underlying fundamentals,
2. Purposely protect against permanent losses, and
3. Aspire to a reasonable, high probability rate of return (vs. extraordinary return).

Typically, when investors desire extraordinary returns, they compromise the integrity of their risk-averse value investing process. And this leads to unwarranted risk and higher probability of risk. The smart investor does not seek extraordinary performance — that’s never the goal.

The goal of the smart investor is to stay within the parameters of a risk averse process. If this is accomplished, extraordinary returns should be within the realm of possibility over time.

As you’ve probably already noticed, none of these ideas relate to the current stock price or what’s “trending” right now. The underlying business is the main concern of the smart investor — not the stock price. The only time the stock price becomes important in the context of investing, is when an investor compares the valuation of the business to the current stock price.

Investors are well served to ignore the often irrational behavior of the market, even when others are benefiting from these behaviors. You’ll likely be better off in the long run by avoiding this speculative behavior. This is how many great investors were able to consistently avoid speculative bubbles that eventually burst (i.e. tech bubble of 2000, housing bubble of 2007/2008).

It takes determination, courage, and patience to succeed as an investor. To have a reasonable probability of worthwhile returns over the long-term, an investor would do well to investment in situations that are:

1. Fundamentally favorable, and
2. Usually unpopular on Wall Street

Investing is not easy. It’s a simple concept to intellectualize, but it’s difficult to execute if you’re not adhering to a sound, risk-averse process. By sticking to this process, the smart investor can rest easier at night knowing they are likely to be better off in the long run.

So what happened to Uncle Howie…?

Well…After a series of questions to help figure out his pain points. He started to see his particular circumstance wasn’t the end of the world.

Next, I asked him if he considered himself an investor or speculator?

This question took him by surprise as he lashed out, "of course I’m an investor."

I put my head down, sighed, gave him some tough love, and said, "Great — but you’re not acting like one."

Knowing who you are as an investor (or speculator) can mean all the difference in making proper decisions when it comes to putting money in the stock market (or anywhere for that matter).

BOTTOM LINE: There is a big difference between investing and speculating. And knowing the difference between the two can mean the difference between success and failure. It takes a great amount of skill to become a great speculator (and I don’t know many). A more passive approach (investing) is likely to yield better results and returns over time – but of course, that’s for you to judge yourself.

The current stock price, or the volatility of that stock price, should never be the main characteristic of buying and selling decisions for the investor. The stock price is only there to compare it to the underlying fundamentals and valuation of the business.

So who are you — Investor or Speculator?

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