In a recent post at 0 to IPO in 7 Years, I made a comment that I did not see enough of a difference between speculation and investment and asked for a clarification. Rocky promptly presented the following crisp definition:
“My definition: A speculation is a holding (of whatever sort) where the success or failure is determined by the expectation that ANOTHER MARKET PARTICIPANT will move the price in a particular direction.
An investment is a holding (of whatever sort) where: (1)There is INTRINSIC value beyond what the market current reflects; and/or (2)The realization of profit is not dependent upon other participants (3) There is a margin of safety such that if one’s calculation of #1 is wrong, the losses will still be minor. …
Of course, I am assuming the survival of the rule of law. But if the rule of law fails, then the only investment will be shotguns and canned goods.
In all events, it has nothing to do with timeframe. It has to do with valuations and discounted cash flows…”
I have noticed that people often consider speculation bad and investment good often equating speculation with gambling and investment with exercise in wisdom. I see most of life as speculation. As a result, I said that the difference between these in the above definition was not sufficient based on the definition of the word speculation.
Here I remember my relatives who live in Tbilisi (Georgia). Armenian language has many dialects and all of them are very sweet for me. While I understand most, some words are used in strange ways in different dialects. While growing up, I’d often hear my relatives in Tbilisi use the word դատել (to judge) in place of “to earn” in a sentence like “that’s how I earn money.” Years later I think I understand a bit better why judging was used in the context of earning a living.
For all practical purposes, Rocky’s definition is excellent but here are some reasons why I think the distinction is not sufficient:
- Determination of intrinsic value requires a judgment. This value is not constant and is based on our perception of value which not only changes externally but also internally. What is the intrinsic value of a company (group of people, machines, processes, patents, under some law) which makes punch cards or floppy disks? What was the intrinsic value of a real estate deed during the Armenian Genocide or the Holocaust? What is the intrinsic value of the few coins left from the times of Tigran the Great? Internally, what is the intrinsic value of an investment when one has greater priorities (or becomes terminally ill)?
- Realization of profit is always dependent on other participants. In a simple real estate rental, tenants are the critical participants. An investment in a project requires above all a great team. Even the discovery of a gold mine requires miners. Sale of Chinese goods requires American consumers.
- Margin of safety can only be computed using the historical and current facts making it fairly unsafe in face of what future may bring. I remember my naive questions when one of my finance professors was explaining how the US government debt was the risk-free investment and all else required a risk premium. Another professor spent half a class explaining RAROC or was it RARORAC. I sat in amazement during another presentation of all the risk controls at Fleet (currently Bank of America).
- The assumption of survival of the rule of law is fairly fundamental considering that laws change frequently. This also assumes that our neighbors (next door and on the other side of the border) under such law will be sufficiently well off. It also assumes no environmental decays due to actions of others (legal but lethal). Also, the rule of which law? Today’s multinationals operate in almost every country. Are we not making a “gamble” that their operations will not materially suffer from actions of countries in which they operate (Venezuela being a recent example)?
A sharp language is an indication of a sharp mind. As expected, Rocky made it more challenging by asking the following rhetorical questions:
“1)If you’re an unskilled laborer, and you borrow $200,000 to go to college to become a skilled electrical engineer… is that an investment or a speculation?
2) If you are a skilled mechanic, and you start your own garage to fix cars … with all of your tools on lease (and no capital down) is that an investment or a speculation?
3) If you are late to a critical business meeting and driving fast — and see a traffic light about to turn red — and also see a traffic cop on the sidestreet — and you don’t slow down…. is that a speculation or an investment?”
I see these as speculation of some sort or another.
- The unskilled laborer may be speculating that recent graduates of electrical engineering will be in demand commanding a considerable salary upon graduation or at some point in the future. The laborer may also be speculating that high inflation in the future will make the $200,000 fixed loan today a wise decision. Unaware of inability to discharge student loans through bankruptcy, the unskilled laborer may be speculating that defaulting on free money may be a great “investment.”
- The skilled mechanic may be speculating that car repair in the chosen area (in a private garage) is going to be in sufficient demand to generate enough cash flows to justify the time spent on the activity (after taxes of course). The skilled mechanic may be assuming that since the tools are owned, they are “free.” The skilled mechanic may not realize that this “investment” may produce less money per hour (even in the long run) than working at a VW dealership. The mechanic may be speculating that a novice will come about a few years later to take the “business” off his hands.
- This I cannot answer as it involves judgement about breaking the law (also I’m the slowest driver I know). 🙂
I hope this has clarified my thinking. Let me finish by saying I strongly dislike (as my son says) being sold “a great investment” as these often represent someone else’s speculation that others will invariably help them reach their goals of prosperity (another loaded word).