Image credit: “Faces of the Bourse: The Fall of the Bear and the Triumph of the Bull, or Men Who Cry and Men Who Laugh,” Honoré Daumier, 1856, The Benjamin A. and Julia M. Trustman Collection of Honoré Daumier Lithographs at Brandeis University.
By Jason Zweig | 12:24 pm ET Feb. 28, 2013
To understand why investment is so tricky to discriminate from speculation, it helps to dip into the historical background.
The words “invest” and “speculate” are both rooted in Latin.
“Invest” comes from the Latin investire, to dress or to clothe – a sense preserved in the word for the appointment of a new pope, “investiture.” The literal meaning of the word “invest,” then, is to envelop or enrobe yourself in an asset.
The earliest appearance of this usage in English, according to the Oxford English Dictionary, is in a letter that Thomas Aldworth, an agent of the East India Co., wrote in 1613, speaking of “goods and monies to bee inuested in commodities fitt for Englande.”
While the term “Intrinsick Value” was often used in England as early as 1720, the word “invest” wasn’t widely applied to financial assets in either Britain or the U.S. until the mid-19th century.
“Speculate” comes from the Latin specula, a lookout post or watchtower, from specere, to see or to look (think of related words like “prospect,” “spectator” and “spectacle,” all related to seeing). The earliest uses of the word in the O.E.D. are from Thomas Jefferson and Alexander Hamilton in the late 1780s, discussing the speculators who were trading distressed debt of the 13 colonies.
By the late 19th and early 20th centuries, most people regarded bonds as investments and stocks as speculations. That popular distinction held regardless of how cheap or promising a stock might be; stocks were viewed as so inherently risky that nothing could turn them into an “investment.”
In a brilliant essay published in 2006 in Financial History, the magazine of the Museum of American Finance, money manager Dennis Butler explored the historical backdrop of Graham’s distinction between investment and speculation.
Before the 1920s, an investor was someone who “aimed for secure income, with absolute safety of principal,” explained Butler. “Only bonds…met these requirements.”
A speculator, Butler pointed out, was anyone who sought “to benefit from a change in market value.” Since stock prices changed more than bond prices, stocks were the natural raw material for speculation.
Exactly this distinction surfaces in an article Graham wrote around 1918 for The Magazine of Wall Street: “Many an investor has remarked to the writer, ‘I never buy stocks. Let the other man speculate. All my money goes into bonds.’”
In other words, today’s conventional definitions of investment (evaluating market price against fundamental value and then holding financial assets, especially stocks, for years at a time) and speculation (trading any financial asset over short time horizons based largely on the hope of getting a better price from a “greater fool”) were nowhere in sight in the early 20th century.
Then, an investor was someone who bought and held bonds; a speculator was someone who traded stocks.
That was even truer after the crash of 1929-1932, when as Graham wrote, “all common stocks were widely regarded as speculative by nature.”
He wanted people to see things differently. Graham insisted that stocks could be investments and bonds could be speculations – all dependent on the price. If a stock’s price is cheap relative to its underlying value as a cash-generating business, that stock is an investment. If a bond is trading above the sum of its maturity value and all its future interest payments, that bond is a speculation.
Graham rightly pointed out that all assets are investments when their market price is cheap relative to underlying value and speculations once their price climbs far above value. He even pointed out, on page 12 of this speech he gave in 1963, that the same asset can be both an investment and a speculation at the same time: Stocks have a fundamental investment value, often with a speculative layer of froth slathered on top of that. In this sense, as Butler points out, Graham may have unwittingly encouraged the blurring of the distinction between investment and speculation that has marked modern bull markets.
But Graham was always adamant in insisting that investors and speculators should never be mistaken for each other.
The Wall Street Journal itself has long confused investors with traders or speculators and, I’m afraid, continues to do so to this day.
The July 12, 1962, edition of The Journal ran a letter from Graham criticizing an article the newspaper had run the previous month under the headline “Many Small Investors Bet on Further Drop, Step Up Short Sales.”
“If these people are investors,” thundered Graham, “how should one define ‘speculation’ and ‘speculators’? Isn’t it possible that the current failure to distinguish between investment and speculation may do grave harm not only to individuals but to the whole financial community – as it did in the late 1920s?”
On Tuesday of this week, the “What’s News” summary on Page One of the Journal announced that “Investors fled stocks, spooked by election results in Italy and the prospect of government spending cuts in the U.S.”
If you dump your stocks merely because Silvio Berlusconi gets a few too many votes or the federal budget might get a sharp belt-tightening, are you an investor? I don’t think so.
As Josh Brown at the Reformed Broker pointed out earlier this week, nearly all commentary about the financial markets is tailored to speculators, not investors. That can contaminate the mind of even the most intelligent investor with speculative thinking. How can you keep your head clear?
As Robert Hagstrom pointed out, it would help if we all could agree on the difference between investing and speculating. I don’t have a perfect definition, but I’ll offer a tentative one. Maybe you can help me make it better.
An investor never buys purely because an asset’s price has been going up and never sells merely because its price has been going down. An investor uses internal sources of return – dividends, rising future profits or asset values – to estimate what an investment is worth.
A speculator buys and sells on the basis of recent fluctuations in price. A speculator uses external sources of return – primarily what he thinks someone else might pay – to estimate what a speculation is worth.
Finally, the label long-term investor is redundant, at least for individuals. If you can’t hold stocks or funds or ETFs or other assets for at least a year at a time, you’re not a short-term investor. You aren’t an investor at all.
Your thoughts? Tell us here by posting a comment or visit Robert Hagstrom’s blog post at Inside Investing.
Source: Total Return blog, WSJ.com: http://blogs.wsj.com/totalreturn/2013/02/28/are-you-an-investor-or-a-speculator-part-two/
Resources:
Benjamin Graham, the Human Brain, and the Bubble (a guest essay for the European Asset Management Association, beginning on p. 145 of this large PDF file)
Benjamin Graham: Building a Profession (anthology of his shorter writings, which I co-edited)
A Rediscovered Masterpiece by Benjamin Graham (full text of Graham speech from 1963 on how to think about market values)
Who Was Benjamin Graham, and Why Should I Care? (compilation of various writings on Graham)
The Heilbrunn Center for Graham & Dodd Investing at Columbia Business School
The Ben Graham Center for Value Investing at Ivey Business School, University of Western Ontario
Online transcripts of lectures by Benjamin Graham
Related: Are You an Investor or a Speculator? (Part One)