Investor or Speculator? (Guest Commentary)
(May 12, 2005)
The joys of writing a stock market newsletter. Over the last couple of weeks, I have been labeled "clueless" and one reader wrote that he felt "sorry for my readers" because he thinks the stock market is going down "hard" this year - but with nothing to justify his claim. I'm sorry, but what version of MS Crystal Ball are you using? Don't you realize that Apple has far superior products? :) But of course, you also meet a lot of great people along the way. I am truly indebted to everyone who has posted to our discussion forum so far. I have learned (you can never stop learning - that is what makes life fun) a lot from all of you who have offered your ideas and who have argued your case. Please keep those posts coming!
As I mentioned on our discussion forum earlier this week, today's commentary will be provided by Mr. Richard Faw. I will start writing a commentary again this weekend. Richard's commentary takes a different route to many of my commentaries - this one is more philosophical in nature and will force you to reflect many of the things you are currently doing (right or wrong) in the stock market. It may even open a Pandora's Box. If it does, then chances are you will not finish this commentary (most people's brains are tuned to avoid pain) - even though you may benefit from it in the long-run. From the emails that I received, I can tell that not many people liked my recent ST bullish call on the stock market, but like I said in my many commentaries over the last 12 months, my main job is to try to gauge the probabilities and come up with my own "best-chance scenario" of where the market is heading both in the short-term (next two to three months) and in the long-term (next two to three years). In the short-term (two to three months is the shortest-term we will go), I am leaning towards the bullish side, even though I still believe we are in the midst of a secular bear market that began in early 2000. In Richard's words, then we are currently speculating (on the bullish side) when it comes to the movement of the next two to three months. The bears who are calling for the market to head south (in a "hard" way) sometime this year are also engaged in speculation. It is merely my word against theirs. Don't let them convince you otherwise.
First of all I believe a little bit of introduction is in order: Richard works as a consultant and his primary focus is designing investment strategies for financing corporate benefit liabilities. His client portfolio design strategies range from indexed equity funds and municipal bonds to derivatives and insurance. He is an actuary and CFA Charterholder and can be reached at RichardFaw@comcast.net. Richard is also a great of Warren Buffett and a very dedicated student to the stock market. Following is Richard's commentary!
My article takes a slightly different angle than the commentary Henry indefatigably provides weekly: this article contains no specific investment ideas, nor does it provide commentary on today's capital market environment. Instead, in the spirit of this website, I hope to encourage thought regarding what investors today are doing with their money. The subject of my discussion is geared toward subscribers who are private individual investors.
The purpose of this article is to address the old debate between investment and speculation, specifically in the area of stocks, and to spark thought on which approach your capital accumulation philosophy falls under. So what is meant by investment and speculation? I prefer Keynes' definitions in The General Theory of Employment, Interest, and Money: in it, he defines "enterprise", which I interpret to be investment, as ".the activity of forecasting the prospective yield of assets over their whole life." and "speculation" as ".the activity of forecasting the psychology of the market."
Speculation and investment are obviously not mutually exclusive, although, I do believe that most people with money in the game fundamentally fit into one bucket or the other - they may speculate in one part of their portfolio and invest in another, but when it comes down to it, I believe that most of us do not evenly straddle the line between those two approaches. Regardless, the key rule, that every investor and speculator in stocks needs to remember is that investors and speculators in a business, in the aggregate, can get no more out of a business over its lifetime than the business produces in cash flow to the owners. The prices will go up and down, but at the end of the day over the long-run, aggregate experience will approximate business performance (Warren Buffett has discussed this in numerous writings).
Unfortunately, the concept of investing is not, in my opinion, necessarily encouraged by every business that deals with financial assets. My favorite is online brokers - almost daily I see ads, whether on TV, radio, newspaper, etc. that beckon you to join the 'revolution' and trade, trade, trade! Note the conspicuous absence of the words 'invest, invest, invest' from that mantra! In my opinion, these businesses have no incentive to encourage you to invest for the long run, because commissions would likely decline (assuming long-term investing involves less frequent trading).
Speculation, on the other hand, is obviously not without its rewards. However, pure speculation, without consideration of any macro or micro fundamentals, is a breeding ground for a dangerous thing: Emotion. If you can speculate but avoid the emotional baggage that permeates most minds when rolling the dice, then I would guess you have a leg up on most speculators. And you must maintain this emotionless activity for the long-term if you are speculator. And the long-term is what matters - the long-term is where the magic of compound interest picks up the economic football and runs for 100-yard touchdowns. So, to really grow your money, you have to work hard at plugging your dollars into opportunities with a high probability of a favorable outcome, after fees and taxes and do it year, after year, after year.
So, what about those chartered with investing the public's dollars: mutual fund managers. Are they investing? We all know that a significant proportion of mutual fund portfolio turnover rates are north of 100%, which, assuming they are investors, seems to imply that they see fundamentals (mostly micro-economic) changing so dramatically every year that they must completely change their portfolios annually to adjust to the changing fundamentals. I don't believe things change this quickly. To be fair, though, the mutual fund business does place a strangle-hold on those managers and impede their ability to make sound long-term high-probability bets on financial assets with solid economics. They are constrained by the negative perception of inactivity and the myopia of a constantly shrinking time horizon where investors are force-fed quarterly performance results (these are supposed to be perpetuities, right?) to cast judgment on relative performance. This is not the healthiest environment for fiduciaries of investors' money to operate under. (For a good read on mutual fund investing, read John Bogle's book Common Sense on Mutual Funds). I do believe, however, that most mutual fund managers intend to operate as investors, although I also believe that the modus operandi of the mutual fund industry does occasionally place certain handcuffs on the managers to make sound investing bets.
So, both investing and speculating can work. Warren Buffett and George Soros are fine evidence of that. The bottom line, though, is to know which game you are playing, play by the rules and risks of that game, and don't let emotion corrupt your decision-making framework. Benjamin Graham laid this out cleanly in The Intelligent Investor (fair disclosure: Graham's definition of speculation differs slightly from Keynes', in that Graham defines it as any "operation" that does not provide ".safety of principal and an adequate return."):
"Outright speculation is neither illegal, immoral, nor (for most people) fattening for the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation, as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose."
So, the challenge here is to compound your money, year-after-year-after-year at a high after-tax rate of return after fees and taxes. How will you do it? If you are a speculator, understand that there are hurdles that must be cleared every year to make it work (e.g., transaction costs, taxes, and emotional recklessness) which are significant and impact the long-term growth of your corpus. If you are an investor, as Warren Buffett discusses in his preface to The Intelligent Investor (can you tell I'm a fan?), you will need the confidence to let your analysis guide your decisions and, as in speculation, the emotional fortitude to stick by those decisions.
To wrap up, I can't resist one more quote regarding this debate and, specifically the potential impact of the interaction of speculation and investment. This one is Keynes again in The General Theory of Employment, Interest and Money:
"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation."
Suitable commentary on the bubble we just experienced, even though it was written over 60 years prior.
Thanks again to Henry for allowing me to share my thoughts on his website. Please feel free to contact me with your thoughts, comments, concerns or disagreements. I can be reached at RichardFaw@comcast.net