Friday, July 22, 2011

Buffett on Speculation and Investment - Part II

A follow up to this post:

Buffett on Speculation and Investment

"The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices." - Benjamin Graham in The Intelligent Investor

Speculators generally focus on price action in the near term.

For investors, it's mostly not about price action, it's about what the asset can produce in the long run relative to what was paid for the asset.

What the price does next week, month, or even much longer matters little.

Speculators take on risk and enable other participants manage/transfer risk. It can be a very useful and beneficial role. Yet, in the markets, the proportion of activity that is pure speculating versus investing matters.

It's not difficult to show that, in many systems, more of what is initially a useful thing creates diminishing returns or worse.

The following may help to illustrate the point.

It's certainly no perfect analogy but consider a petrol engine. It happens to operate best when the stoichiometric air-fuel ratio is very near 14.7 to 1 (mass ratio of air to fuel present during combustion). Get much above or below that ratio and the engine performs poorly (or not at all). In other words, it's not like more fuel is always better. Eventually too much fuel destroys performance.

So there is a narrow operating range around that ratio for the engine to perform its best. For a petrol engine, the air-fuel ratio for optimum performance happens to hover around 14.7 to 1.

Of course, I'm not suggesting that specific ratio -- or any precise ratio -- applies to capital markets. With too much air a petrol engine simply won't run. That's not necessarily the case for capital markets. Clearly, any system involving lots of temperamental human participants could never have such precision. So just because it's not working optimally doesn't mean it won't work at all. Still, I think it's fair to say the market has developed in ways that are way beyond being even in the ballpark of an optimal ratio of speculators (i.e. the air) in proportion to the investment-oriented participants (i.e. the fuel).

The equivalent to an "air-fuel" ratio for the markets has, in my view, become more than just a bit out of balance in recent years. The relatively small amount of actual investing compared to substantial speculation, and in some cases pure gambling, is making the market engine run a bit lean.*

The assumption that more is better, even when it's something initially beneficial, is where I think a mistake is being made. There's this prevailing belief that if some initially beneficial added market liquidity is good then anything short of an infinite amount more of it must be better. I think it is wise to be a bit skeptical of this.

"A modest amount of liquidity will service the true needs of a civilization. A large amount of liquidity will bring out the worst in human nature." - Charlie Munger at the 2008 Wesco Financial Shareholder Meeting

Buffett makes a further distinction between speculation and gambling that I'll address in a follow-up.

Adam

Related posts:
Buffett on Gambling and Speculation (follow-up)
Buffett on Speculation and Investment

* Running either rich (too much fuel) or lean (too little fuel) means lost performance in an engine.
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