Posted by jasonzweig on Dec 12, 2016 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  Dec. 9, 2016 2:40 pm ET

With the stock market seemingly setting all-time highs every day even as bond prices crumple, this is a crucial time to clarify the difference between investing and speculating.

Unfortunately, that distinction — often credited to the great investment analyst Benjamin Graham — has never been entirely clear. Every asset is an investment in some people’s hands and a speculation in others’. So it isn’t what you buy, but rather why you buy, that determines whether you are investing or speculating.

In his classic 1934 book Security Analysis and again in The Intelligent Investor (1949), Graham wrote: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory [or ‘adequate’] return. Operations not meeting these requirements are speculative.”

I used to regard that description as definitive, but I began to see its flaws a few years ago. Can any analysis ever be thorough enough to “promise” safety or a positive return?

The traditional view, dating back at least to the 19th century, is that an investor buys to capture a predictable long-term stream of cash flow, while a speculator buys to harvest a short-term change in price.

But if you purchase 100 acres of raw land and hold it undeveloped for a half-century because you expect the area to turn into a suburb, are you an investor? The property produces no rent or other income. And you can profit only if, decades from now, someone pays you a higher price after inflation. What sounds like an investment is largely a speculation.

If you bought Amazon.com when it first sold shares to the public in 1997 at $1.50 (adjusted for stock splits) and have held it ever since, are you a speculator? The stock has shot up past $765 per share, with staggering swings up and down along the way; the company doesn’t pay a dividend and often hasn’t even reported a profit.

But you bought Amazon because you reasoned it would transform the world of retailing, and you hold it — even though the stock trades at more than 175 times its earnings — because you think the company isn’t done with that transformation yet. Your original speculation has grown to resemble an investment.

Someone else buying Amazon for a quick turn in the stock price — say, a rise from $1.50 to $2 twenty years ago, or from $750 to $766 this year — is a speculator. Same asset, same time, different motivations and horizons.

It isn’t just that the same asset can simultaneously be an investment and a speculation depending on who holds it and why. The same person can be an investor and a speculator at the same time.

Surveying 210 clients who each traded at least 120 times per year, discount brokerage Fidelity Investments found that they restricted their short-term trading to 37% of their total assets on average.

“When you talk to them in person,” says senior vice president Drew Brownsword, “they’ll say, ‘I’m not an active trader, I’m an investor who trades.’”

Barry Metzger, a senior vice president for trading services at Charles Schwab, says some active traders “wear that as a badge of honor” and “believe that trading is fun and a part of who they are.” Other investors who trade a small portion of their portfolios regard that activity as only “a means to an end.”

Benjamin Graham advised strictly segregating your speculations from your investments. The best idea: Set up a “mad money” account where you can take a flyer, if you must. Limit it to, say, 5% of your total and never add more.

“There’s an element of the speculator in everybody,” says Rob Arnott, chairman of Research Affiliates, a firm in Newport Beach, Calif., whose strategies are used to manage about $165 billion.

So it’s important, before committing any money to any asset, to ask yourself why you want to. “Picture a continuum running from speculator at the far left to investor at the far right,” says Mr. Arnott. “If you buy this asset, where are you on that continuum?”

Why does it matter? If you think you’re investing, when in fact you’re speculating, a collision with reality could knock you off-course.

Dennis Butler, who runs Centre Street Cambridge Corp., an investment adviser in Cambridge, Mass., offers this example: If, with stocks at record highs, you buy an index fund because you think that’s a safe way to earn annual returns of at least 10% a year, then you’re speculating. If, on the other hand, you buy an index fund knowing that “stock prices are high and future returns will be lower as a result,” he says, then you’re investing.

I would add: If you buy because you’re afraid of being left behind should stocks keep booming, you’re speculating. If the market’s rise makes you worry instead and look to rebalance your portfolio by selling some of what’s gone up and buying some of what’s gone down, you’re investing.

Source: The Wall Street Journal, http://on.wsj.com/2hct5G9

Related:

What’s Speculating? What’s Investing? Some of the Wisest Investors Weigh In

 

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