WS: INTELLIGENT INVESTOR II - Investment vs Speculation

INTELLIGENT INVESTOR II

All of human unhappiness comes from one single thing: not knowing how to remain at rest in a room. -- Blaise Pascal

Investment vs Speculation

What do we mean by "investor"? Ben Graham only uses this term as a contradistinction to "speculator." As far back as 1934, in his textbook Security Analysis, he attempted a precise formulation of the difference between the two, as follows: "An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

But even during his day, not to mention in more modern current times, Ben Graham noted the radical changes that occurred in the use of the term "investor." After the great market decline (Great Depression) of 1929-1932 all common stocks were widely regarded as speculative by nature. Certainly a similar situation occurred after the Great Bubble (dot.com) burst in 2000. Thus Graham was forced to defend his definition against the charge that it gave too wide scope to the concept of investment.

By the 1960s, Graham's concern had shifted to the opposite sort, a concern that persists in the media yet today. He wanted to prevent readers from accepting the common jargon which applies the term "investor" to anybody and everybody in the market. Graham emphasized his concern by citing a newspaper headline from The Wall Street Journal in June 1962:

SMALL INVESTORS BEARISH, THEY ARE SELLING ODD-LOTS SHORT

In October 1970, Graham noted the journal had an editorial critical of what it called "reckless investors," who this time were rushing in on the buying side.

These quotations, in Graham's mind, well illustrated the confusion that had been dominant for many years in the use of the words investment and speculation. Think of Graham's suggested definition above, and compare it with the sale of a few shares of stock by an inexperienced member of the public, who does not even own what he is selling, and has some largely emotional conviction that he will be able to buy them back at a much lower price (short selling). Graham further noted that when the 1962 headline appeared the market had already experienced a major decline and was preparing for an even greater upswing. It was about as poor a time as possible for short-selling. In a more general sense, he noted, the later-used phrase "reckless investors" could be regarded as a laughable contradiction in terms (an oxymoron)--something like "spendthrift misers"--were this misuse of language not so mischievous.

The newspaper employed the word "investor" in these instances because, in the easy language of Wall Street, everyone who buys and sells a security has become an investor, regardless of what he buys, or for what purpose, or at what price, or whether for cash or on margin. Compare this with the attitude of the public toward common stocks in 1948, when over 90% of those queried expressed themselves as opposed to the purchase of common stocks. About half gave as their reason "not safe, a gamble," and about half, the reason "not familiar with." It struck Graham as ironical (though not surprising) that common stock purchases of all kinds were quite generally regarded as highly speculative or risky at a time when they were selling on a most attractive basis, and due soon to begin their greatest advance in history (the "roaring 60s"); conversely the very fact they had advanced to what were undoubtedly dangerous levels as judged by past experience later transformed them into "investments," and the entire stock-buying public into "investors."

The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. Graham often said that Wall Street as an institution would be well advised to reinstate this distinction and to emphasize it in all its dealings with the public. Otherwise the stock exchanges may some day be blamed for heavy speculative losses, which those who suffered them had not been properly warned against. Ironically, once more, much of the recent financial embarrassment of some stock-exchange firms seems to have come from the inclusion of speculative common stocks in their own capital funds. Graham hoped the reader of his books would gain a reasonably clear idea of the risks that are inherent in buying stocks--risks which are inseparable from the opportunities of profit that they offer, and both of which must be allowed for in the investor's calculations.

What Graham is saying is that there is no such thing as stock market investing without risk-- no sure thing. Every investor must recognize an inescapable speculative factor in buying and holding common stocks. It is the investor's task to keep this component within minor limits, and to be prepared financially and psychologically for adverse results that may be of short or long durations. There is no way around this market fact.

Graham adds two more paragraphs about stock speculation per se, as distinguished from the speculative component of investing. Outright speculation is neither illegal, immoral, or (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities for 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, Graham notes the foremost 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.

In Graham's conservative view, every nonprofessional who operates on margin (investing with money borrowed from your broker with your shares as collatoral) should recognize that he is ipso facto speculating, and it is his broker's duty so to advise him. And everyone who buys a so-called "hot" stock is either speculating or gambling. Speculation is always fascinating, and it can be a lot of fun while you are ahead of the game. If you want to try your luck at it, put aside a portion-- the smaller the better-- of your money in a separate fund for this purpose. Never add more money to this account just because the market has gone up and profits are rolling in. (That's the time to think of taking money out of your speculative fund.) Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.


Credit: Parts of this article are extracted or modified from Ben Graham's classic The Intelligent Investor, 1973.

POSTED :05 Jun 2006