The importance of understanding the differences between investment and speculation
As a small-business owner, it can be difficult to decide where to invest your hard-earned money. Do you invest your earnings back into your small business or do you diversify, investing your cash into stocks, bonds, real estate, or other investments? Reinvesting in the small business, where the owner has control, and where cash flows are more transparent, often is a great answer, but it can bring risks. If the small business fails, the personal finances of the owner are crushed. On the other hand, investing in stocks, bonds, and real estate bring diversification benefits, but this can also feel like speculation, or even gambling, to an experienced small-business owner.
The fintech revolution introduced modern brokerage platforms that allow investors to buy and sell stocks, bonds, real estate, and alternative investments at a frightening pace. This has only reinforced the misguided notion modern investing is more of a speculative game. Navigating the landscape of financial products and services can become quite daunting, making it difficult to differentiate between investment and speculation. Here are some investing fundamentals to stay grounded.
FUNDAMENTALS OF INVESTING
The primary goal of investing is to build wealth over time by purchasing assets that will increase in value or generate income. The key to ensuring you’re investing and not speculating is based on your method of evaluating assets. Benjamin Graham defines the core principles of value investing in “The Intelligent Investor,” which was first published in 1949 and is still widely considered to be one of the most influential books ever written on investing. Graham’s emphasis on fundamental analysis while leaving a “margin of safety” provides a framework for investors to evaluate an asset. One of the most successful investors of all time, Warren Buffet, was a student of Graham at Columbia Business School and has often cited him as a major influence on his investment philosophy. Considering that Buffet has applied many of these principles throughout his career and achieved unparalleled success, his recommendation holds significant weight in the investment world. On the following page, you can find a breakdown of how Graham differentiates investing and speculation.
1. BASIS IN ANALYSIS
Before investing, one must analyze financial statements, assess the company’s competitive position, understand the industry landscape, and evaluate the experience and track record of management. The purpose of this research is to determine if the security is undervalued relative to its actual worth. An investment should only be made after a thorough analysis of the intrinsic value of an asset. One common method used for this is a discounted cash flow analysis.
2. SAFETY OF PRINCIPAL
Minimizing risk of loss is very important. This does not mean avoiding risk entirely, but every effort should be made to reduce risk of permanent loss. By purchasing securities at a price far below their intrinsic value, one can establish a “margin of safety.” This will protect your investment from potential negative events in the future that may lead to a drop in the security’s price.
3. ADEQUATE RETURN
For a purchase to be considered an investment, it should offer a reasonable expectation of return. This may be derived in the form of capital appreciation, interest, or dividends. The expected return also should correlate with the level of risk associated with the security.
1. BASIS IN PRICE MOVEMENTS
Rather than focusing on intrinsic value, speculation often involves making a purchasing decision based on anticipated price movements. Short-term price fluctuations can be influenced by a variety of factors such as news, rumors, or popular ideas. Making a purchase based on these factors isn’t very different from gambling.
2. PRINCIPLE AT RISK
The pursuit of higher rewards often requires taking on more risk, as well as accepting higher levels of volatility and unpredictability. Since fundamental analysis isn’t required, decisions can be made too quickly. This inevitably places your capital at risk of loss.
3. POTENTIAL FOR GREATER LOSSES
By focusing on greater short-term gains, you’re often positioning yourself for the possibility of greater losses. The correlation between risk and return must be considered.
4. PSYCHOLOGICAL FACTORS
Market sentiment often shifts back and forth between fear and greed. Often, speculation is heavily influenced by whatever sentiment seems to be dominant at the time. Rather than focusing on intrinsic value, trades based on market sentiment can often lead to bubbles and crashes.
WHY WE INVEST
Any investor should have a strong bias toward investing rather than speculation, but brokerage platforms, and some brokers, too often have a financial incentive to encourage trading, pushing investors to be speculators. The investor should be aware of these influences. The investor should also consider the big picture. Investing in a company also means investing in the management team – smart leaders who are focused on creating value over the long term just like the small-business owner. Yes, the markets can fluctuate wildly, but the investor can see through the day-to-day news to the underlying business model, anchored in analysis, to stay the course.