Investing versus Speculation

 What is the difference between investing and speculation?

Benjamin Graham addressed the differences between them on the very first page of his book, The Intelligent Investor.

Graham wrote, "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return."  

Based on this definition, there are three components to investing:  

• thorough analysis, 
• safety of principal, and 
• adequate return.  

Graham added, "Operations not meeting these requirements are speculative."

To this, we can add:

(1)  Any contemplated holding period shorter than a normal business cycle (typically 3 to 5 years) is speculation, and 

(2) any purchase based on anticipated market movements or forecasting is also speculation.

Value investing meets Graham's definition of investing, addressing on:  its focus on individual company analysis to determine intrinsic value,  the margin of safety concept, and its success over the long term.

The distinction between investing and speculation is important for a reason Graham cited in 1949 and remains true today:  "... in the easy language of Wall Street, everyone who buys or sells a security has become n investor regardless of what he buys, or for what purpose, or at what price...."

The financial media often refers to "investors" taking profits, bargain hunting, or driving prices higher or lower on a particular day.  However, these actions are rightly attributed to speculators, not investors.

Investors and speculators approach their tasks differently.

Investors want to know what a business is worth and imagine themselves as owning the business as a whole. Unlike speculators, investors maintain a long-term perspective—at least 3 to 5 years. They look at a company from the perspective of owners. This means they’re interested in factors such as corporate governance, structure, and succession issues that may affect a company’s future and its ability to create wealth for years to come. Investors may use their voting rights to assist in enhancing company value over the long term.

Speculators, on the other hand, are less interested in what a business is actually worth and more concerned with what a third party will pay to own shares on a given day. They may be concerned only with short-term changes in a stock’s price, not in the underlying value
of the company itself.

The problem with speculation is simple:

• Who can predict what a third party will pay for your shares today, tomorrow, or any day?  

• Stock market prices typically swing between extremes, stoked by the irrational emotions of fear and greed.

Focus on the long term business value

Such dramatic price fluctuation on a day-to-day basis can test long-term investors’ mettle in maintaining their focus on business value.

• Remember, the tendency is for business values day-to-day to remain relatively stable.
• Day-to-day price changes should hold little interest for the long-term investor, unless a price has fallen to the “buying level” that represents a sizable margin of safety.

But that’s often difficult to remember when newspaper headlines, TV news anchors, friends, and coworkers are lamenting or lauding the market’s most recent lurch forward or back.