Wednesday, January 2, 2013

On Speculation and Investment

In The Intelligent Investor, Benjamin Graham had this to say about the difference between an investor and a speculator:

"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

Speculation is an emphasis on price action instead of what an asset can produce over time.

As John Bogle points out in this Wall Street Journal article, John Maynard Keynes held a similar view:

...Mr. Bogle cites another legendary figure, British economist John Maynard Keynes, who drew a similar distinction between investment, or "forecasting the prospective yield of [an] asset over its whole life," and speculation, or "forecasting the psychology of the markets."

Investment places an emphasis on what an asset itself can produce over time.

From this interview with Warren Buffett:

"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return. So if I buy a farm and I expect it to produce $80 an acre for me in terms of its revenue from corn, soybeans etc. and it cost me $600. I'm looking at the return from the farm itself. I'm not looking at the price of the farm every day or every week or every year. On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation." - Warren Buffett

So, in contrast, speculation places an emphasis on near-term price action and how to profit from it. He added this in a separate interview on CNBC:

"So there's two types of assets to buy. One is where the asset itself delivers a return to you, such as, you know, rental properties, stocks, a farm. And then there's assets that you buy where you hope somebody else pays you more later on, but the asset itself doesn't produce anything. And those are two different games. I regard the second game as speculation." - Warren Buffett

By almost any measure, speculation in marketable securities and their derivatives is more popular than ever these days. Well, the problem is that achieving above average risk-adjusted returns is not a popularity contest. It's about making consistently sound judgments over time. Later in the same CNBC interview:

"I bought a farm 30 years ago, not far from here. I've never had a quote on it since. What I do is I look at what it produces every year, and it produces a very satisfactory amount relative to what I paid for it.

If they closed the stock market for 10 years and we owned Coca-Cola and Wells Fargo and some other businesses, it wouldn't bother me because I'm looking at what the business produces. If I buy a McDonald's stand, I don't get a quote on it every day. I look at how my business is every day. So those are the kind of assets I like to own, something that actually is going to deliver, and hopefully deliver to meet my expectations over time. A piece of art, you know, may go from $1,000 to $50 million, but it's dependent on what the next guy wants to pay me. The art itself— the painting itself is not going to dispense cash. So I have to find somebody that's going to like it more." - Warren Buffett

The Wall Street Journal article also points out that John Maynard Keynes, during his time, was concerned about speculation and its influence on the markets.

Interestingly, in his thesis as a student at Princeton back in the early 1950s, John Bogle expressed optimism about speculation losing out to investment over time. He now admits that was the wrong view and that the Keynes view was right. According to the Wall Street Journal article, Bogle predicted the following in his thesis a little over 60 years ago:

Mr. Bogle predicted a "steady, sophisticated, enlightened, and analytic" demand for securities from the growing investment-management industry—a demand based essentially on the intrinsic performance of a corporation instead of the public's opinion of the value of a share. 

 "I was wrong and he [Keynes] was right," says Mr. Bogle flatly. The "enlightened" demand for securities that he'd predicted is now in short supply, he says, while speculative demand has soared.

To me, the evidence more than just suggests market participants have an easy choice to make if they want, all risks considered, improved results. Even though speculation (the emphasis on price movements) now dominates over investment (the emphasis on returns generated via the productive capacity of the asset), an investor can choose the latter and let others incur the heavy costs.
(It matters not at all whether the asset is owned 100% or partially via marketable stocks.)

With speculation, the frictional costs (commissions, fees, taxes etc.) and the mistakes that get made* are real, but the good news is that a true investor doesn't have to foot the bill.

Gambling, even if frictional costs are ignored**, is inherently a zero-sum game. Similarly, speculative trading adds nothing in aggregate and, once all costs are taken into account, actually subtracts from returns. In contrast, investment need not be a zero-sum game (if, for example, a business with durable advantages is owned long-term and the investor generally doesn't overpay) since the intrinsic value of a productive asset can increase over time. The size of the pie is not fixed.

Ultimately, the returns for market participants as a whole is dictated by what the underlying assets produce over the long haul minus all the frictional costs.

A sound investment will increase intrinsically in value because of what the asset produces over time.

Of course, that means if an investors picks a subpar asset, the pie could also easily be shrinking.

Consider this. A market participant (with a long position) that reacts positively about prices going up in the near-term likely has a more speculative approach. A market participant (again, with a long position) that reacts positively to an asset they've already bought cheap (w/value judged correctly) getting even cheaper is clearly more investment-oriented.***

Of course, both investors and speculators eventually expect prices to be higher, but the reasons why (psychological factors versus growth in intrinsic value derived from the income produced) and the time frames couldn't be more different.

Now, there is nothing inherently wrong with speculation, of course.

In fact, speculation has its place but the proportion in markets matters. Just because a little bit of something might be a good thing doesn't make more of it even better. If the capital markets become just a giant casino they're unlikely to be operating optimally. The $ 33 trillion of annual trading compared to just $ 250 billion of actual capital raising (less than 1%) that's been noted by John Bogle seems far from optimal.

Still, my emphasis here is on what makes sense for the individual market participant, not the system-wide implications. I think it is more than fair to say that those with a long-term horizon are usually being unwise choosing the more speculative route.


Related posts:
Bogle on the Financial System
Graham on Investment: "Most Intelligent When It Is Most Businesslike"
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

* Buying, for example, during euphoric market environments while selling during unpleasant, sometimes quite scary, market environments. In other words, doing the opposite of what usually works well in the long run. It's quite clear that many participants make repeatedly this mistake even if they underestimate the fact that they're susceptible to it. Things like overestimating capabilities, overconfidence, and loss aversion (among others) are destroyers of long-term returns.
** Of course, frictional costs are, in many instances, far from immaterial.
*** Since more shares can be bought cheap by the investor and the company's free cash flow can be used to buy shares below intrinsic value to the benefit of continuing shareholders. Buffett provides a useful explanation of this using IBM as an example. Also, here's a prior post on the same subject:

Why Buffett Wants IBM's Shares "To Languish"

So a long-term investor shouldn't generally want shares of a sound business to go up in the near-term. It's better if it stays low. What's an exception to this? Here's one scenario to consider. Unfortunately, there's the very real risk that a buyout offer comes in at a premium to market value but a discount to intrinsic value. If enough owners are okay with the gain that will have occurred compared to the recent price action, the deal may be approved. If too few have conviction about longer run prospects, the deal may get approved. When too many owners of shares are in it for the short-term or, at least, primarily to profit from price action, the chance of this happening increases. Well, those that became owners because of the plain discount to intrinsic value and the company's long run prospects will likely get hurt in this scenario.
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