THE SOUTH AFRICAN INDEX INVESTOR
“Greater rewards, lower costs”
Investment versus Speculation
If investing in the stock market is a risky prospect in any event, why bother to distinguish between investments and speculation? Well, it is a matter of attitude and modus operandi. In the former, you have some, if not clear, idea what and why you are buying with a long-term objective in mind. In the latter, you are following the gossip with no or little understanding of the intrinsic value of the asset you acquired in the hope that you will be able to sell at a handy profit in the not too distant future.
Many stories, tips and “advice” found in the popular media often relates to speculative issues rather than genuine long-term investment commitments. It is any event much more sensational to discuss stocks that doubled in price over the last year than some “boring” stalwarts. But, since the media and the like do not differentiate between the concepts, it does not mean you do not have to either.
Speculation is not necessarily bad, in fact, without speculators no money would ever have been raised for new capital projects and major technological developments. But it is a bad idea if you speculating when you think you are investing, or speculating seriously instead of as a pastime without the proper skill and knowledge, and risking more than you can afford to lose.
Benjamin Graham, in his 1934 textbook Security Analysis, gave probably the best definition of an investment: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
From the above definition the following three central insights can be identified:
1) You must thoroughly analyse a company and the soundness of its business, before you buy its stock;
A stock is not just a ticker symbol; it represents an ownership interest in a business with an underlying value that does not depend on its share price. An investor calculates what a stock is worth, based on the value of the underlying business. A speculator, on the other hand, gambles that a stock will go up in price because somebody else will pay even more for it. For a speculator the constant stream of stock quotes is vital, but for the investor price quotations is much less relevant. Arguably, you would probably be better off by not knowing the daily share price.
2) You must protect yourself against serious losses;
The stock market is very much like a pendulum that forever swings between unsustainable optimism and unjustified pessimism. Ideally, an investor should buy from the pessimists and sell to the optimists. However, how would you know whether you are not perhaps too optimistic about acquiring assets at their present prices?
Benjamin Graham devised the theory of “margin of safety”, which is probably the single most important rule when making investments. The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be. No matter how careful you are, the one risk that cannot be eliminated is the risk of being wrong. Only by following the golden rule of never overpaying, no matter how exciting an investment seems to be can you minimise your odds of error.
3) You must aspire to “adequate”, not extraordinary returns.
Speculating can be exciting and very rewarding, but, like gambling, the game is “designed” so that at the end you will lose. On the other hand, with investing you cannot lose in the end, so long as you play by the rules that put the odds squarely in your favour. But, be warned: our human nature tends to drive us towards speculative behaviour. How do you keep that kind of behaviour out of your investment strategies?
Accept first and foremost that the secret to your financial success is inside yourself. Become a critical thinker who takes no “expert view” on faith, invest with patient confidence and refuse to let other people’s mood swings govern your financial destiny.
“In the end, how your investments behave is much less important than how you behave.”
Source: “The Intelligent Investor: Revised Edition” by Benjamin Graham and updated by Jason Zweig, 2005.