Speculation vs. Investing

(Note: this article discusses the public markets, not VC/PE)

I was at dinner with a friend a few weeks back. After we had exchanged initial pleasantries, we began discussing the performance of our respective investment portfolios. One of his investments, Tesla (an investment I explicitly warned against), was one of his top performers. There is nothing wrong with buying stock in Tesla. My friend is a trend analyst interested in “the future” (I scratch that itch through my firm, Ascender Ventures), and his investment thesis for Tesla can be summed up as the following: Elon Musk is a badass and electric cars are the wave of the future. My friend is (probably) correct about both assertions: Elon Musk is a fantastic CEO and innovator, and electric cars are more than likely the wave of the future. But notice how I used the words “probably” and “more than likely.” What my friend does isn’t considered investing. Rather, it’s speculation.

To many, speculating and investing appear to be one of the same. You buy an asset with the hope that the asset’s price will appreciate and you can sell it for more than you paid. So in that sense, they are the same. However, the act of purchasing an asset doesn’t automatically equate to “investing.” Before we delve deeper into the differences, I think it beneficial to provide the dictionary definition of each.

Speculation(noun): 1) the forming of a theory or conjecture without firm evidence. 2) investment in stocks, property, or other ventures in the hope of gain but with the risk of loss.

Investing(verb): 1)Expend money with the expectation of achieving a profit or material result by putting it into financial schemes, shares, or property, or by using it to develop a commercial venture. 2) devote (one’s time, effort, or energy) to a particular undertaking with the expectation of a worthwhile result.

Let’s pay attention to the second definitions of both words. Looking at speculation, although the first word in the sentence is “investing”, there is an element of “hope” attached. A speculator hopes his purchase will generate a profit. Analyzing the definition of “investing”, we see a clear difference. There is no “hope” attached to the definition. In today’s paradigm, speculation is buying an asset after conducting marginal fundamental analysis praying for appreciation. Often, speculation is manifest through the purchase of derivative securities (like swaps, futures contracts, and options.) Don’t get me wrong — speculation is imperative in capitalist societies. Important good and important bad. Speculation provides the capital markets with the liquidity necessary to ensure buyers and sellers can initiate transactions. In other words, there will always be a buyer of what you are selling WHEN you want to sell it. On the other hand, speculation fuels the growth of bubbles. Bubbles are a big no-no. The 2000 internet crash was due to a bubble driven to extremity via speculation. Every crash from the 1630’s tulip bubble to the recent housing bubble can be attributed to irresponsible speculation.

Looking at the second definition of “investing,” we see the words “devote” and “expectation”. See the difference? Hope vs. expectation.
Value investors (like myself), think investing is a long and arduous undertaking involving deep analysis of financial statements, earnings growth, and expected economic GDP growth with the end-goal of finding a large enough discrepancy between the price of the asset and the intrinsic value of the asset to make it worth owning on the “cheap”.(much more is involved with value-based analysis, but we will save that topic for another day). This investment strategy is therefore not speculation because it’s grounded in value analysis. Value analysis, and a necessary confidence in that analysis allows you to have an emotional advantage over your peers. Speculators (given their lack of knowledge about the underlying asset), might succumb to market sentiment or fear of permanent loss. Value investors, on the other hand, understand the value of the asset and can wait for the value and the price to equal each other. So in that sense, investing is much more challenging and way less sexy. Luckily for everyone, there is a second definition of investing that is actually easy (still not sexy at all).

During one of Berkshire Hathaway’s annual shareholder meetings, Tim Ferriss (hopefully some of you have heard about this man. If you haven’t, do yourself a favor and do so ASAP) asked Warren Buffet something along the lines of “If I’m thirty years old and have a few hundred thousand dollars saved up, how should I invest it?” Warren responded “put it all in an index fund and get back to work”. Warren leans over to his business partner, Charlie Munger (another investing genius), and asks “Charlie, have anything to add?”. To which Charlie responded “nope”. The moral of the story is that, unless you plan to be a professional investor, put your money in one of two things

— ETF’s (http://www.investopedia.com/terms/e/etf.asp)

— Index Funds (http://www.investopedia.com/terms/i/indexfund.asp)

These securities enable the lay investor to achieve market returns, consistently, year over year, without paying bloated fees. The expense ratios for many ETF’s are .04%. Basically nothing. These investments are a basket of securities that track a specific index (Like the S&P 500) or a specific sector (the financial sector ETF). Supporters of this investment philosophy believe speculation and fundamental analysis (the cornerstone of value and growth investing) alike are a fool’s undertaking. Given the fact that investing in equities is a zero-sum game, there is always a winner and loser. And when the sobering reality sets in that you are up against many of the world’s best and brightest with access to the same information as you, it’s better to invest in the entire market or an entire industry as opposed to an individual security, opening yourself to individual security risk. Even the best value investors (or growth investors, for that matter) agree that ETF’s and Index funds are a great way to invest your money and gain market returns on an annual basis.

Bottom Line: Speculation is exhilarating and can sometimes be profitable. If your goal is to invest in companies to learn the ropes of the stock market and hope for a big payday, then speculation is fine. Shoot, early-stage investing is by and large speculation! I am by no means without speculative tendencies. But — if your ultimate goal is to achieve long-term financial success and capital appreciation, make sure you are investing. Whether that means becoming a fund manager and learning the intricacies, or just continuing to do your job and invest in index funds, actual investing almost always provides a superior outcome when compared to speculative investment strategies. And that’s what investing is all about…securing financial freedom and making a buck or two.

Thanks for reading, everyone!