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Stepan Lavrouk
Stepan Lavrouk
Articles (345) 

What Is the Real Difference Between an Investment and Speculation?

The distinction is not as clear-cut as you might think

December 04, 2019

What is the difference between investing and speculating? As a value investor, you may think that the answer to this question is simple. Benjamin Graham, often considered to be the father of value investing, once said that an investment must promise safety of principal and a satisfactory return, and that an investment not meeting these criteria is actually just speculation.

More broadly, most of us have a general sense of what the difference is: An investment feels legitimate, while speculation can feel unsavory. Most ordinary people have no problem with the idea of someone putting their hard-earned cash into a business; betting on the movement of currency pairs rarely draws similar reactions.

The changing face of speculation

But beyond these fringe cases, it turns out the distinction between the two is not so clean-cut. Moreover, this distinction has evolved and shifted over time. Back in Graham’s time, buying stocks was considered to be a speculative activity. Today, this attitude seems very odd as stocks make up the bulk of most people’s retirement plans.

In the 1920s and 1930s, the stock market was much more of a Wild West environment. Information on companies was hard to come by, insider trading and market manipulation were commonplace, fraud was widespread and there were relatively few laws and regulations to prevent all of this mischief from happening. As a result, many common stocks were nothing more than claims on dubious businesses with little supporting them.

The other reason why stocks were considered speculative was the fact they do not carry any guarantee of future cash flows. Bonds carry a legally-binding obligation to pay the bearer with cash at set periods in the future. Stocks do not. The management of the issuing company does not have to pay out dividends; indeed, many large companies today - like Google parent company Alphabet Inc. (GOOG) (GOOGL)  - do not pay any dividends at all, a situation that would have seemed very strange to investors in Graham’s day.

What is speculation today?

As the above example demonstrates, practices that were once considered speculative can, over time, come to be considered "respectable" investments. What about the reverse? Is there a form of investing today that our descendents will shake their heads at, and wonder why it wasn’t considered speculative? My theory is that history will look at the venture capital industry and conclude that pumping billions of dollars into tech companies that lose money quarter after quarter was not investing in the sense that Graham defined it.

As value investors, we need to be cognizant of the fact that markets have a tendency to run away and that in boom times, there is typically too much money chasing too few deals. In such environments, there will be many people who will try to convince both you and themselves that their reckless behavior is not speculative. Don’t let yourself be fooled.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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