Monday, May 01, 2006

Investment vs Speculation

In every bull run the media reports are full of the references to the
return of the Small Investors to the equity markets. Lured by the
headlines of Sensex crossing 8000 and stories of neighbor making huge
money, otherwise intelligent people, decide to try their luck in the
markets.

I find the word Small Investor little misleading. The term is used for
the people who are really Small Speculator but think that they are
investing. It is very important to make the distinction between the
two. Any advise which is valuable to the investors, can be dangerous
for the speculators. Before I go on to explain this I want to put
forward the definition of investment as given by Benjamin Graham

"An investment operation is one which, upon thorough analysis promises
safety of principal and an adequate return. Operations not meeting
these requirements are speculative."
Graham and Dodd's Security Analysis (original 1934 edition)
http://www.amazon.com/exec/obidos/ISBN=0070244960/investorhomeA/

Graham goes further to suggest that speculation is not wrong but
entirely different ball game and should not be confused with investment.

"Outright speculation is neither illegal, immoral, nor (for most
people) fattening to the pocketbook . . . There is intelligent
speculation as there is intelligent investing. But there are many ways
in which speculation may be unintelligent. Of these 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. . . everyone who buys a so-called "hot" common-stock
issue, or makes a purchase in any way similar thereto, 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, put aside a portion--the smaller the better--of your
capital 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 funds.) Never mingle your speculative and investment
operations in the same account, nor in any part of your thinking"

Benjamin Graham in The Intelligent Investor
http://www.amazon.com/exec/obidos/ISBN=0060155477/investorhomeA/

When you speculate on a stock while thinking that you are investing,
the time tested principles of investing can do you more harm than
good. For instance take "Buy and Hold" approach. The investors who
have done property analysis can afford to hold the stock even if the
price goes down. If they are really sure about their reasoning they
can (and they should) increase their investment as the price goes
down. The same is not true for the speculator who is investing in a
penny stock. He can lose his entire amount just by waiting for the
time stock goes up.
The same goes with diversification. If you buy all slots of a
roulette, you have a 100% chance of losing money equal to the %
charged by the Casino. Similarly if you try to be a contrarian when
you know less than what market knows you would lose more that you
would by following the trend.

That brings me to the question I want you to answer for yourself. Are
you sure that you are not a speculator?
If you don't know the answer then you can get the answer the
following question.
(a) Do you know about the main products/business of the company you
have invested in?
(b) Can you tell , with (+-)50% accuracy, the revenues or profits of
the company.
(c)Have you ever checked the financials or results of the company?
(d) Do you have some reasonable expectation about the returns from the
money you have put in the stock and have you compared those
expectations with the returns available from other non-equity
investments?
(e) Do you have some estimate on risk that you are undertaking, e.g in
worst-case scenario how much you can lose.
(f) Have you done more than a day of homework per stock before forming
your expectations and risk estimates?

If you answer more than 4 of the above question as NO than you are
definitely an speculator irrespective of your opinion. If you have
answered at least one NO then you would be better of undertaking
investment under guidance from experts. Finally, if you have answered
all of this as yes it is difficult to guess whether you are an
investor but you are definitely on the way.

None of the points mentioned above are for discouraging or disparaging
speculation. Very few people in the group would know that I'm an
expert gambler but I never speculate in the markets….And I know, it
pays to be really sure when you are speculating.

Posted:
Oct 19, 2005
http://in.groups.yahoo.com/group/lawarrenbuffet/message/1588

1 comment:

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Interesting comparson.