Speculation vs. Investment

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:

investment by ~tuck3621
investment by ~tuck3621

“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:

  1. 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)?
  2. 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.
  3. 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).
  4. 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)?
I truly appreciate Rocky’s definition but I feel that in all cases we speculate regarding a particular outcome or a set of outcomes based on all our knowledge, understanding, and wisdom.

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.

  1. 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.”
  2. 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.
  3. 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).

11 Comments

  1. I have a very simple method of defining speculating and investing:

    -investing means you are expecting your profits to come from an increase in the intrinsic value of the assets you are holding
    -speculating means you are expecting your profits to come from price oscillations around the intrinsic value

    Of course, defining and, more importantly, determining intrinsic value is a different issue.

  2. LD: You wrote that you see most of life as a speculation. But can you provide at least one example of an investment?

    Is worship an investment? Is having children an investment? Is buying Inflation-Linked Bonds an investment? Is saving for college in an FDIC insured account an investment?

    If you cannot illustrate an investment, then I think we are having a philosophical discussion — and not a practical one. As previously disclosed, I slept through my philosophy classes at Yale … so I cannot be any help…

    Rocky

  3. Rocky – They are all investments and they all involve speculation. I was hoping to illustrate that there is little difference between these.

    The practical implication is to recognize a wolf in sheep’s clothing when being sold an “investment” regardless of how “credible” the seller may be (with the most credible of them all being our government). Often even the seller does not fully recognize (hence disclose) the relevant risks. This is far from being philosophical especially for most ordinary folks and even smart institutions who recently lost significant balances following the advice of trusted “investment advisers.” Do you think folks would be as likely to follow advice if it came from a “speculation adviser?”

    While it may take less than a second for select folks like yourself to measure up most of the risks of any proposition, I am deeply bothered by an article like this one. This is at the institutional level. What happens at the individual level I am afraid is even less encouraging.

    Often a long-term speculation or one involving a less liquid instrument is considered an investment. Sometimes dishonesty is internal and very subtle having the effect of us sticking by a losing gamble labeled a long-term investment. In these cases, The First Law of Rocky may come to rescue but when the second occurrence takes place we’re often overwhelmed by either greed or fear.

    I really appreciate your clear definition above but was hoping to bring out some of these additional points.

  4. LD:
    Your comment touches on many important points. I’d argue that the least important point is distinguishing between “speculating” and “investment.”

    For time immortal there have been unscrupulous sellers and gullible purchasers. This is true in all facets of life — whether it’s a cult leader handing out kool-aid … or a bond salesman misrepresenting a security.

    I’m sympathetic when folks are preyed upon by unscrupulous or fraudulent market operators (because that is the entire logic behind regulation.) However, I’m entirely unsympathatic when supposedly qualified market participants, take risks to achieve excess returns, and then cry “foul,” when they discover that there is a downside to risk-taking. (As they say in the fine print: “Investments CAN lose money. Past performance is no guarantee of futures results.”)

    Lastly, this episode underscores an important silver lining: WE LIVE IN A FREE SOCIETY — that permits us to make choices (both good and bad). Noone forced anyone to buy a mortgage backed security. Noone forced anyone to buy a dot com stock. (And I didn’t. And most folks didn’t either.) However, now that I am more bullish on equities than I’ve been in almost 20 years — whether I am right or wrong — I have that choice.

    My greatest fear is the sort of emotions which you are feeling become widespread, and lead to more nanny-statism — where the “wise men” of government make decisions for the individual. Freedom of choice is a bedrock of long term happiness and prosperity.

  5. Rocky – I did not think a link would be made between what I wrote and more regulation but I can now see how you came to that. The target here is the individual who must recognize the speculative nature of investing. Overtaken by greed and lulled into a state of no fear, the individual (representing an institution, or a family) made certain decisions. The rest is history.

    Members of different professions suggest solutions based on their specialty (lawmakers – more laws and regulations, programmers – new computer models, rating agencies – new rating criteria and controls, psychiatrists – an evaluation and analysis of the mind, etc.) in many cases ignoring the fundamental responsibilities of understanding all possible consequences that come with freedom of choice.

    My fear is that even at such a high price tag to all of us critical lessons are not learned by many and even if learned are likely to be ignored by another generation.

  6. This page seems as applicable today as it was when it was first written where it is said “Of these the least troublesome arise from the misuse of the term “investment” to cover the crassest and most unrestrained speculation. If that were the only cause of our investment difficulties, it could readily be cured by readopting the old-time, reasonably clean-cut distinctions between speculation and investment. But the real problem goes deeper than that of definition. It is bound up not with the grotesque failure of speculation masquerading as investment but with the scarcely less calamitous failure of investment itself, conducted in accordance with time-honored rules.”

  7. LD:

    I think we agree. (per your post of 4/10 7:33am). Investments entail risks. There is no riskless activity in life — except perhaps death.

    I think your citing of Ben Graham is apt — as his hedge fund was down 70% at the depths of the great depression. (Little solace to his investors, but that outperformed the market!).

    But, at the end of the day, (or decades), the economy will heal; profits will grow — and another bull market will unfold. People will (again) point to the fact that stocks produce better returns than every other asset class — and when that’s again consensus, I’ll be slowly selling the stocks that I bought during the depths of despair. (And I’ll probably sell way too early too!)

  8. I wonder if President Obama was considering the various definitions of speculation or investment when he (by mistake, I’m sure) failed to confirm his earlier (pre-election) position on the Armenian Genocide.
    After all, the Armenian’s should just ingnor the facts, as did President Obama, and let by-gones be by-gones in an effort to move relations forward with Turkey.
    He failed to visit Normandy and the thousands of graves of American Service Men who “invested” their lives for the freedom of Europe. He did not have time on his busy apology tour to recognize how America came to the worlds aid in that tragic era. Perhaps it did not happen. He would like for the Armenian people to “cave in” and forget facts in an effort to achieve reconciliation.
    Just my conservative bias!
    Mike

  9. Excellent points. I’m writing a story on investment vs. speculation as it pertains to the stock market and would like to quote you in my story. Please email me if you’d like to participate.

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