Are You an Investor or a Speculator?

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By Jason Zweig. Original here http://blogs.wsj.com/totalreturn/2013/02/28/are-you-an-investor-or-a-speculator-part-one/ and here http://blogs.wsj.com/totalreturn/2013/02/28/are-you-an-investor-or-a-speculator-part-two/

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Are You an Investor or a Speculator?
Do you know?

A

s Hagstrom said to me earlier this week, “An accountant knows the difference between a debit and a credit, an attorney knows the difference between a felony and a misdemeanor, a doctor knows the difference between a virus and bacteria. So how is it that the financial industry can’t define the difference between investing and speculation?” If you think you are investing when, in fact, you are speculating, you’re likely to be surprised by worse losses than you can imagine. If your financial adviser speculates with your account when you want only to invest, you will get saddled with risks you aren’t likely to withstand. But what exactly separates investors from speculators? I thought I knew, but now I’m not so sure. When Hagstrom first contacted me a few weeks ago to chat about the idea, I immediately retorted with words I learned by heart more than 20 years ago, first written by the great financial analyst Benjamin Graham in 1934: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”¹ Is it that simple? In his 1934 masterpiece, Security Analysis, Graham elaborated on the definition. He used the term “investment operation” rather than “investment” because sometimes “the element of safety is provided by the combination of purchase and sale.” Graham often engaged in merger arbitrage, buying one stock or bond involved in a corporate takeover while selling or “shorting” securities of the company on the other side of the deal. Or, during a corporate reorganization in a bankruptcy, he might buy one type of a company’s securities while shorting others issued by the same company. In these and other types of hedging, the safety and return are the result of an “operation,” simultaneously buying and selling more than one security at a time. Graham added: “By thorough analysis we mean, of course, the study of the facts in the light of established standards of safety and value.” Continued Graham: “The safety sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations…. a safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experience indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation.”

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Finally, Graham explained, “A satisfactory return…is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.” Much to my surprise, once I thought through Graham’s classic definition point by point, I found that it wasn’t quite as watertight as I had always believed. If merger arbitrage is an investment operation, then what about today’s widespread practice of “statistical arbitrage”? A stat-arb trading firm might, for example, buy all the underlying stocks in an exchange-traded fund and simultaneously short-sell the ETF if it believes that the ETF is slightly overvalued. These firms use no leverage or borrowed money; they “go home flat,” closing out all their positions at the end of the day to minimize risk. Some of these same firms are otherwise known as high-frequency traders; they hold their positions for only hours, often even only a few minutes, at a time. Typically they use no human judgment whatsoever, guiding their “operations” purely with lightning-fast computer programs that tap directly into trading data provided by the stock exchanges. Is that investing? The very suggestion that high-frequency traders might, in fact, be “investors” seems absurd and repugnant. But how, other than their short time horizons, do the operations of such traders differ from the arbitrage that Graham himself believed to be a form of investing? And if there is a minimum holding period required for someone to be considered an “investor,” how long is it? It’s hard to believe that anyone who keeps a stock for only a few minutes at a time can be investing, but where is the dividing line? Is the minimum holding period one month? One year? If so, bear in mind that the average holding period among U.S. mutual-fund managers is 11 months, according to Morningstar – meaning that the typical fund manager isn’t “investing.” Is it three years? (Why?) Is it five? (Why?) Furthermore, Graham’s argument that “where study and experience indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation” isn’t entirely satisfying. No matter how thorough your analysis of an asset, there is always an appreciable chance of loss – as Graham knew better than anyone. As careful an analyst as he was, he lost roughly 70% in and after the Great Crash of 1929. In the 1972 edition of his book The Intelligent Investor, he warned that a stock investor must reconcile himself to the “probability” rather than the “possibility” that “most of his holdings” will fall by at least 33% several times over five-year periods.

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So, it seems, “an appreciable chance of loss” is a part of investing as well as of speculating – by Graham’s own admission. 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.

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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?”

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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.

Jason Zweig

Are You an Investor or a Speculator?

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