Everyone wants to be an investor, but few understand the difference between investing and speculation. Even though investors like Warren Buffett (Trades, Portfolio), Seth Klarman (Trades, Portfolio) and the godfather of value investing, Benjamin Graham, have all tried to extol the differences between investment and speculation, even today most investors are unaware of the difference between the two.
This is a big mistake. Without realizing the difference between investment and speculation, you put yourself on a dangerous path, one that could end up costing you a significant part of your wealth.
Investment vs. speculation
An investment can quite simply be defined by Graham’s original description of the topic:
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
This statement does go some way to defining the difference between investment and speculation, but it leaves a lot to be covered. In Graham’s view, an investment is something you analyzed and know exactly what you are buying. I am sure most people would argue they have always done their research before initiating a position, but this does not necessarily mean the stock is an investment and not speculative.
Graham’s "Intelligent Investor" has been republished many times, and one of the most recent issues contained commentary by acclaimed financial journalist Jason Zweig, who has done plenty of research on Graham, Buffett and the general topic of value investing in the past. In the commentary, Zweig does an excellent job of decoding Graham’s guidance above and providing more insight for readers. Specifically, he boils down the statement into the following three points:
- You must thoroughly analyze a company, and the soundness of the underlying businesses, before you buy its stock.
- You must deliberately protect yourself against serious losses.
- You must aspire to “adequate,” not extraordinary, performance.
Buffett on speculation
I think these points do a better job of defining investment versus speculation than Graham’s initial wording. Investment is all about achieving stable, long-term returns and preventing the permanent loss of capital. What’s more, to invest you have to be investing in a company’s cash flows, if there are no cash flows and you are only betting on the price of the stock or price of an asset, it can be argued the activity is purely speculative. As the "Oracle of Omama" has explained before:
“...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.”
So those are the guidelines to help you figure out whether or not your so-called investment activity is actually speculative in nature. If you still do not understand the difference between investment and speculation, Buffett has some advice to help you distinguish between the two:
“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.”
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