Are You Investing or Speculating?
Do you invest or speculate?
Take a moment and think that question through... because how you answer will tell you a whole lot about why you have or haven’t been making money.
Before I give you a chance to answer, we first need to define an investment and a speculation.
More than 80 years ago, while teaching at Columbia Business School, Ben Graham wrote a book called Security Analysis, where he defined them.
Graham was the first to define those terms... something no one ever thought about doing before him.
He said that an investment “is one which, upon thorough analysis, promises safety of principal and an adequate return.”
Anything that did NOT offer safety of principle and an adequate return, he defined as a speculation.
If you put $10,000 into the latest touted penny stock, obviously it would not be an investment. While a penny stock may offer an adequate return, it would not have the promise of safety of principle.
The promise of safety of principle means that it is highly unlikely the company or investment will go bust and you’ll lose all your principle.
Clearly, putting money in a penny stock, since it doesn’t pass the two criteria of an investment, is a speculation. In other words, be prepared to lose all your money.
Speculation Becomes an Investment
Can the same stock be both an investment and speculation? Absolutely!
During periods when stock prices are selling at nosebleed valuations, investing in them would not offer an adequate return... despite promising safety of principle.
Let me give you an example.
Wal-Mart (NYSE: WMT), Coca-Cola (NYSE: KO), and Microsoft (NASDAQ: MSFT) are three companies that have ironclad balance sheets.
There is a slim to almost zero chance that an investor will suffer a total loss investing in any or all three of these stocks.
All three pass the first hurdle of being defined as an investment: they promise safety of principle.
But what about adequate return? It’s here that it gets a bit tricky.
At the height of the dot-com bubble, all three of them were selling at very high valuations... between 39x and 50x earnings.
To offer an adequate return, these companies would have to earn high double-digit earnings for the next five years, a feat that is close to impossible.
Investing in these stocks at the end of 1999 would have been defined as a speculation — there was no way they could continue to trade higher.
If you invested equally among of all three of them thinking you were investing instead of speculating, you would have been in for a rude awakening. Over the next 10 years, here are the compounded annual returns:
You could’ve done much better investing in a Treasury bill earning interest.
However, if you invested in these same three stocks when they were offering an adequate return, your returns would have been a whole lot better.
From the end of 2009, these three stocks were still trading at bargain prices. Over the next seven years, you would have made out very nicely. Here are the compounded annual returns over that period:
In both cases, an investor had the opportunity to invest in these stocks; however, in 1999, they would have been considered a speculation, and in 2009, an investment.
That is why it is so important to first define what you are doing with your money BEFORE you invest it. You need to ask yourself: am I investing or speculating?
Don’t try and convince yourself that you're investing when you are really speculating. Because at the end of the day, the only person you’ll be fooling is yourself.
All my best, Charles Mizrahi Twitter: @IWPeditor Charles cut his chops on the trading floor of the New York Futures Exchange before moving on to become a wildly successful money manager on Wall Street. And with more than 35 years of recommending stocks under his belt, Charles has knocked the cover off the ball, compiling an amazing record of success and posting gain after gain for his loyal readers. He is the editor of Park Avenue Investment Club and the Insider Alert newsletters. Charles is also the author of the highly acclaimed book, Getting Started in Value Investing.
All my best,
Charles cut his chops on the trading floor of the New York Futures Exchange before moving on to become a wildly successful money manager on Wall Street.
And with more than 35 years of recommending stocks under his belt, Charles has knocked the cover off the ball, compiling an amazing record of success and posting gain after gain for his loyal readers. He is the editor of Park Avenue Investment Club and the Insider Alert newsletters.
Charles is also the author of the highly acclaimed book, Getting Started in Value Investing.