Investment and speculation are different things

In this series, we’ll look at the difference between investment and speculation, and investment and spending.

Even if you’re not that much into finance, it’s wise to know the basics, not just to make sense of the world and feel smugly superior to pundits (who may represent the lowest known form of life), but more importantly to you personally – to help you make smarter choices with your own money.

Investment vs. speculation

There is an enormous difference. You’d be surprised how many people, including many whose jobs it is to know, don’t know, at least not in a clear and conscious way.

Aside from plain old ignorance, the reasons are partly cosmetic: “Investing” sounds good, while “speculation” is a bit of a dirty word. So people prefer to talk about investing even when they’re quite obviously speculating.

The confusion is so common that many people don’t know what it is they’re doing with their money. That’s every middle manager who has a few shares of whatever, because that’s part of his aspirational identity.

The essential difference is this:

• Investment is based on changes of value.
• Speculation is based on changes of price.

You may now feel there is a grey area between them, where they can mix. You’re right if you do. But most of the time, the difference is clear enough to make a binary distinction useful.

For an easy, ideal example, investing is when you buy and plant an apple seedling, wait for it to grow (and/or actively care for it), and then sell the fruit for a steady stream of income, or the grown tree itself for much more.

Speculation is buying an apple tree and selling it at a higher price, while it hasn’t changed or done anything. Nothing wrong with that, but its important to keep the difference in mind.

Other differences:

• Investment tends to be long term (fundamental value usually grows at ponderous pace), speculation tends to be shorter term. An investor might rebalance his or her portfolio only rarely when conditions change, whereas a speculator might make tens or even hundreds of operations a day and spend much time imagining meaningful information in the random walk of markets.

• Investment is based on fundamentals, speculation on sentiment.

• The strategy of investing is countercyclical, whereas speculation is cyclical. Speculative thinking writ large is at work in asset bubbles – when people are buying when prices are already high, hoping they will get even higher, relying on “momentum”, and selling in panic when prices drop. By contrast, dips are buying opportunities to an investor, and bubbles the time to cash out. Buying when everybody is selling and selling when everybody is buying helps counteract the excesses and balance prices out through elementary supply and demand. Speculation amplifies market cycles and volatility, investment mellows them out.

While investment is preferable for immediately practical reasons – you’re likely to get your ass bitten off by your own mistakes if you speculate heavily – there’s nothing inherently wrong with speculation, assuming information symmetry between participants.

For example, when something is worth more to Albert than Bertie, it makes sense for you to buy from Bertie and sell to Albert. It makes even more sense for them to make the trade directly without you, but if one of them needs the money now (and this is more important to him than getting paid more later), and the other doesn’t have it yet, and you do, you can help them by buying from Albert and later selling to Bertie at a profit.

The liquidity and time value of money are the two factors missing from popular narratives that explain how everybody won in that scenario. Of course, this is an ideal case and the real world is rather more complicated, and so is the morality of speculation. The point is it can be a good thing.

High frequency trading, for instance, is pure speculation, which serves the positive function of providing liquidity to the markets. That’s guy-in-tie-speak for “Whenever you want to sell something, there’s somebody buying at a fair price, and vice versa”. That was not always the case before the robots.

There are criticisms. “Hurr durr high frequency traders are unfair to mom-and-pop investors who can’t compete with supercomputers that make 10,000 trades a second hurr durr!” Well, no. The computer infrastructure the HFTs paid for is the reason mom-and-pop investors can make trades for 0.1 cents, rather than 5% of each transaction. Mom-and-pop investors and margin-milking supercomputers are not competitors, they’re symbionts, because mom-and-pop are not speculators. Supercomputers and heavily leveraged idiots who think they can beat the market by reading news in a bathrobe are competitors, but the reason the latter end up obliterated is not the supercomputers.

If you have balls of steel, excellent information, the discipline of a zen monk and better yet, a corruptible cousin on the board of a publicly traded company, by all means speculate. If you want to protect and grow your wealth without exposing yourself to too much risk or spending half your free time obsessing over things you can’t control, you should invest.

The risk profiles and payoffs bring us to the golden rule of personal finance:

Invest everything you don’t immediately need.
Speculate only with what you can afford to lose.

Read that until you see it seared into your retinas when you close your eyes, unconsciously assemble the words out of breakfast cereal and mutter it in your sleep.

I’m just gonna say it once more for your benefit:

Invest everything you don’t immediately need.
Speculate only with what you can afford to lose.

An investor needs a solid, consistent strategy that won’t be swayed by “market weather”. A speculator needs the opposite – flexibility to adapt to quickly changing conditions.

A successful investor must have a cool head, and make peace with the fact that he will have lower profits than the cowboys during bubbles, or even be ridiculed for insisting on outdated concepts like diversification, due diligence and common sense. But when the cowboys are obliterated by a correction, a rational investor writes off a part of his profits (rarely principal) and carries on.

The strategy for successful investing has been excellently described decades ago and remains constant. If you read one book about this stuff, choose this.

If you read anything else, avoid purported miracle recipes to beating the market, which in a fashion much similar to miracle diets work in one case out of a thousand under the right conditions, for a while, until they don’t.

If a book looks anything like “WHAT WALL STREET DOESN’’T WANT YOU TO KNOW – HOW I BEAT THE MARKET for two weeks, before I lost everything and had to resort to writing dishonest books”, re-read Graham instead.

On valuations

I’m gonna talk mainly about stocks, because non-speculative, reasonably safe bonds barely return inflation these days.

Buy companies with long term growth prospects, and those you believe are undervalued or overlooked by the market.*

*A relatively new type of buying opportunity is a dip after a blue chip company’s inevitable corruption scandal in China. Since nothing big happens in China without corruption, scandals say basically nothing about the ethics of the company. Corruption scandals in China mean that somebody higher up in the Party asked for a huge bribe, didn’t get it and retaliated by blowing the whistle on his underlings and western imperialist pigdogs.

“But the Party launched an anti-corruption initiative…”

No, the Party launched a corruption consolidation initiative, to ensure money flows in pre-designed channels up the chain of command, without independent structures, side branches, pools and eddies. Different things. But I digress.

There is, on average, a degree of correlation between price and value of a stock, but its far from absolute. The interesting stuff happens precisely in the exceptions – the cheap good, which you need to buy, and the expensive bad, which you recommend to people on Yahoo Finance (an eerily perfect name).

Cheap doesn’t have to mean undervalued. Many cheap companies are simply bad.

By the same token, expensive doesn’t have to mean overvalued. Many expensive companies are really good and deserve the valuations.

Valuations reflect future expectations more than the present, which is how companies that lose money can still be massively valuable if they’re losing money for the right reasons (we’ll get to that in a minute). This also explains Tesla, which is valued like a company ten times its size, because it has the potential to turn the car industry inside out within a decade, and also because it is currently the only way to buy stock in Elon Musk, which is difficult to overvalue.

In fact, when a growth company spends more money than it makes, that’s a good thing – it means it has more ideas than capital, which means good things for the future when the investments it is now making start to pay off. That’s an excellent thing. It’s much better than a mature company sitting cluelessly on a hoard of cash, because it ran out of ideas.

While the latter may seem like a conservative investment, it’s actually incredibly unsafe. Stagnant behemoths are riskier investments in any longer term view than well-selected growth companies.

Conclusion

Contrary to popular perceptions, investing is for everybody. In fact, it is the only option where you’re not actively fucking yourself over.

If you have anything saved up, you have a choice to either collect zero or negative interest on it in some savings account bullshit (which is the bank giving you pennies now actually charging you while making multiple percent on your money per year), or buy a basket of ultra-conservative dividend stocks and high-grade bonds, and have it return 3-5% every year on top of any price changes (trending up long-term). And you can cash out anytime.

What’s better, this or paying for not having access to your money for thirty years, while it shrinks? Because that’s the deal now.

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