The stock market’s gain since its March 2020 low may have convinced some investors to attempt to profit from short-term price movements. They may have made large gains from their holdings in a short period of time, and could feel that heightened market volatility presents an opportunity to make a quick profit in the future.
However, speculating on stock market volatility is an arguably more risky pursuit. A more efficient use of your capital is to follow Benjamin Graham’s preference for investing, instead of speculating, and to focus on company fundamentals rather than short-term stock price movements.
The risks of speculating
Investing and speculating differ in that speculators seek to make a quick profit from a short-term stock movement. Meanwhile, investors take a long-term approach to managing their portfolio.
Speculation is considered a high-risk activity because it is impossible to accurately predict the stock market’s movements. There are an infinite number of variables that can affect stock prices over the short run. They represent known unknowns that no individual can accurately forecast ahead of time.
As such, it could be argued that investing in stocks for the long term is a lower-risk activity. It does not seek to predict the stock market’s future price movements. Instead, it focuses on company fundamentals and valuations. Investors can therefore deduce whether a company is financially sound and capable of producing improving levels of profitability. They may also seek to determine whether a business offers good value for money at its current price to gauge its capital growth prospects over the long run.
As Graham once said, “The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices.”
Using market fluctuations to your advantage
Investors can still use short-term market fluctuations to their advantage – even if they do not seek to buy and sell securities over a short time period.
Short-term market volatility provides investors with the opportunity to buy quality companies at low prices. This enables them to obtain a wide margin of safety that may push the investment odds further in their favor.
At the moment, many sectors continue to be unpopular among speculators due to their short-term risks. For instance, leisure companies and energy stocks trade at low valuations compared to their past averages. This may present an opportunity for investors to capitalize on weak sentiment among speculators to take advantage of low valuations.
Graham previously highlighted how investors can use changing sentiment to their advantage: “The intelligent investor is a realist who sells to optimists and buys from pessimists.”
Maintaining a stable mindset
Volatile market conditions such as those experienced in the first half of 2020 can cause investors to worry about the short-term performance of their portfolio. They may even begin to speculate on the near-term prospects of their holdings. For instance, they could decide to sell their stocks after a market crash to try and prevent further loss.
However, the stock market’s past performance suggests that volatile periods are commonplace. For instance, over the past 75 years, the S&P 500 has experienced 14 bear markets where share prices declined by more than 20%.
In spite of its volatility, the stock market has produced annualized returns in the high-single digits over the long run. Avoiding the temptation to speculate on its short-term price movements due to heightened emotions and using a long-term buy-and-hold strategy could therefore apportion your capital more efficiently.
As Graham once said: “The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances.”
Read more here:
- Buffett, Klarman and Graham on Taking Advantage of Market Uncertainty
- Charlie Munger on the Value of Efficiency
- Howard Marks on Generating Market-Beating Returns
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