the Market Truth

Below is an attempt to distinguish between investor and speculator in the equities markets. Draw your own conclusions - personally I see little difference after considering the examples and evidence provided.

Excerpt from "Investor or Speculator?" by Henry To:

The purpose of this article is to address the old debate between investment and speculation, specifically in the area of stocks, and to spark thought on which approach your capital accumulation philosophy falls under. So what is meant by investment and speculation? I prefer Keynes' definitions in The General Theory of Employment, Interest, and Money: in it, he defines "enterprise", which I interpret to be investment, as "...the activity of forecasting the prospective yield of assets over their whole life..." and "speculation" as "...the activity of forecasting the psychology of the market."

Speculation and investment are obviously not mutually exclusive, although, I do believe that most people with money in the game fundamentally fit into one bucket or the other - they may speculate in one part of their portfolio and invest in another, but when it comes down to it, I believe that most of us do not evenly straddle the line between those two approaches. Regardless, the key rule, that every investor and speculator in stocks needs to remember is that investors and speculators in a business, in the aggregate, can get no more out of a business over its lifetime than the business produces in cash flow to the owners. The prices will go up and down, but at the end of the day over the long-run, aggregate experience will approximate business performance (Warren Buffett has discussed this in numerous writings).

Unfortunately, the concept of investing is not, in my opinion, necessarily encouraged by every business that deals with financial assets. My favorite is online brokers - almost daily I see ads, whether on TV, radio, newspaper, etc. that beckon you to join the 'revolution' and trade, trade, trade! Note the conspicuous absence of the words 'invest, invest, invest' from that mantra! In my opinion, these businesses have no incentive to encourage you to invest for the long run, because commissions would likely decline (assuming long-term investing involves less frequent trading).

Speculation, on the other hand, is obviously not without its rewards. However, pure speculation, without consideration of any macro or micro fundamentals, is a breeding ground for a dangerous thing: Emotion. If you can speculate but avoid the emotional baggage that permeates most minds when rolling the dice, then I would guess you have a leg up on most speculators. And you must maintain this emotionless activity for the long-term if you are speculator. And the long-term is what matters - the long-term is where the magic of compound interest picks up the economic football and runs for 100-yard touchdowns. So, to really grow your money, you have to work hard at plugging your dollars into opportunities with a high probability of a favorable outcome, after fees and taxes and do it year, after year, after year.

So, what about those chartered with investing the public's dollars: mutual fund managers. Are they investing? We all know that a significant proportion of mutual fund portfolio turnover rates are north of 100%, which, assuming they are investors, seems to imply that they see fundamentals (mostly micro-economic) changing so dramatically every year that they must completely change their portfolios annually to adjust to the changing fundamentals. I don't believe things change this quickly. To be fair, though, the mutual fund business does place a strangle-hold on those managers and impede their ability to make sound long-term high-probability bets on financial assets with solid economics. They are constrained by the negative perception of inactivity and the myopia of a constantly shrinking time horizon where investors are force-fed quarterly performance results (these are supposed to be perpetuities, right?) to cast judgment on relative performance. This is not the healthiest environment for fiduciaries of investors' money to operate under. (For a good read on mutual fund investing, read John Bogle's book Common Sense on Mutual Funds). I do believe, however, that most mutual fund managers intend to operate as investors, although I also believe that the modus operandi of the mutual fund industry does occasionally place certain handcuffs on the managers to make sound investing bets.

So, both investing and speculating can work. Warren Buffett and George Soros are fine evidence of that. The bottom line, though, is to know which game you are playing, play by the rules and risks of that game, and don't let emotion corrupt your decision-making framework. Benjamin Graham laid this out cleanly in The Intelligent Investor (fair disclosure: Graham's definition of speculation differs slightly from Keynes', in that Graham defines it as any "operation" that does not provide "...safety of principal and an adequate return."):

"Outright speculation is neither illegal, immoral, nor (for most people) fattening for the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation, as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose."

So, the challenge here is to compound your money, year-after-year-after-year at a high after-tax rate of return after fees and taxes. How will you do it? If you are a speculator, understand that there are hurdles that must be cleared every year to make it work (e.g., transaction costs, taxes, and emotional recklessness) which are significant and impact the long-term growth of your corpus. If you are an investor, as Warren Buffett discusses in his preface to The Intelligent Investor (can you tell I'm a fan?), you will need the confidence to let your analysis guide your decisions and, as in speculation, the emotional fortitude to stick by those decisions.
To wrap up, I can't resist one more quote regarding this debate and, specifically the potential impact of the interaction of speculation and investment. This one is Keynes again in The General Theory of Employment, Interest and Money:

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation."

Suitable commentary on the bubble we just experienced, even though it was written over 60 years prior.

What many fail to realize, including this author, is that any investment is a speculation. Personally, I place equal weight on a professional analysts ability to predict the future performance of a company as my ability to predict the price of crude oil in 5 years - pure luck with consistency coming as an illusion. The author makes the important acknowledgement of the place of emotion in the life of the speculator, further hurting the odds of success for the aspirer.

However, it seems as though he fails to realize that even with the absence of emotion, success is no where near assured for speculation nor for investing. Finally, towards the end of the article he seemingly subconsciously blurs the two terms when discussing the importance of a lack of emotional interference in speculation as well as in investing by paraphrasing Mr. Buffet's words.

To conclude, even the author himself eventually, perhaps even unbeknownst to him, acknowledges the lack of differentiation between the two terms "investor" and "speculator". This article will hopefully serve as a good transition into a discussion of speculation (read: investing), the myth of technical/fundamental analysis as useful tools for predicting, and in time, how to profit from the markets from real edge. Stay tuned.