Is speculating different from investing? Is investing different from speculating? The answers, of course, are yes and yes. There are real and specific differences between the two, and it’s crucial to distinguish between them.
Speculating involves buying a risky asset in the hope of selling it at a profit within a short period of time. It is a bet that the price will go up. Speculation relies on the Greater Fool Theory, the idea that one can make a questionable investment today while being confident that an even “greater fool” will come along and take it off one’s hands at an even higher price.
In many cases, speculators are drawn to an asset or security whose price has recently gone up dramatically. Examples include consumer stocks in the late 1980s, so-called dot-coms in the late 1990s, Florida condominiums in 2006, and Bitcoin in 2021. Lured by the meteoric rise of these assets—the past performance—many, many investors were burned badly when they joined the party late, just in time to participate in the popping of the bubble. As famed investor Sir John Templeton once said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”
Former speculators will tell you that speculating was great until the point they suddenly realized that there were no more “greater fools” out there and that they themselves were the fool. It was at this moment that they also realized they had just lost a pile of money they couldn’t afford to lose. And finally, former speculators will tell you it was then that they gave up being a speculator and became an investor.
So what does it mean to be an investor? In contrast to speculating, investing is rooted in the understanding that the value of any asset (stock, bond, real estate property, or private company) today is determined by the cash inflows and outflows—discounted at an appropriate discount rate—that can be expected to occur during the remaining life of the asset. Said another way, the value of an enterprise today is simply the net present value of all future cash flows expected from the enterprise.
This definition of value was first used by economist and investor John Burr Williams more than 80 years ago. One can use this “net present value of all expected future cash flows” approach with real estate, stocks, private equity, bonds, or most any type of investment. Were you to purchase a residential real estate property, you would carefully determine your purchase price by considering the potential rental income and the expected future sales proceeds (terminal value) upon eventually selling the property. An institutional investor does the exact same thing when considering buying a two million-square-foot office building.
Likewise, many stock investors use this approach to value stocks. “What price per share will I pay today if I expect earnings per share to be X for the next N years and I expect my eventual sales price to be Y? As an owner of this company, what will I receive in the form of cash flows in the future and how much am I willing to pay for those future expected cash flows today?” This is investing.
The past year has seen a rise in speculative activity in the stock market. When COVID-19 forced the closing of casinos and suspension of collegiate and professional sports, a whole new generation of market speculators was born. Budding retail investors could download Robinhood.com in minutes and start trading. Web sites like Reddit’s WallStreetBets hosted discussions on market opportunities and launched aggressive trading strategies. Internet posts of lucky windfalls abounded and fueled the trend. The promise of getting rich quickly was irresistible to many.
With its volatility over the past year, the stock market became a casino for these nascent traders. From March 2 through March 23, 2020, the S&P 500 dropped 24.26%. It took just sixteen business days to wipe out roughly a quarter of its value. Fear and panic gripped the markets. However, the market rebounded more quickly than most anticipated and from March 23 through December 31, the S&P gained 62.96%, reaching an all-time high.
Financial news outlets were filled with stories of speculative bets that paid off big. For example, on July 22, 2020, Eastman Kodak had closed at $2.16. A week later, it hit a high of $60 per share before closing at $33.20, a return of roughly 1,422% over a period of five trading days. And by the way, Eastman Kodak has not had a profitable year since 2017. In the grand tradition of the California Gold Rush and the internet stock craze, would-be profiteers piled in.
While a few lucky speculators may make a killing on their bets, vast numbers do not. Speculation works great when you get into an asset early and your bet starts to take off. However, it can be highly dangerous if you risk what you can’t afford to lose, get in too late, have unrealistic visions of potential gains, or become emotionally attached to your investment. Speculative plays should be viewed purely as casino bets. For example, putting $20 on black in roulette will not financially cripple you if you lose. However, putting $200,000 on black and losing could be devastating. As Warren Buffett has said,
“Speculation is most dangerous when it looks easiest.”
Admittedly, occasionally a speculative bet can pay off. I consider myself a long-term investor. My wife and I own a diversified portfolio that is very similar to the portfolio owned by Bragg clients and we review it quarterly; we are not day-traders. However, I had been following the saga of cinema chain AMC since early January 2021. I’m an avid movie fan; before the pandemic, we would go see a couple movies every month at our nearest AMC. I did a deep dive into AMC’s financial statements and researched the industry dynamics, including the number of blockbuster movies put on hold during the pandemic. These films are scheduled to be released between 2022 and 2025.
When AMC hit $6.00 a share, I spoke with my wife and we agreed to invest a very small amount—roughly $3,000—in the company. AMC had avoided bankruptcy and I thought that it was probable it could reach $15 a share in a few years. However, the company was still unprofitable, the future was uncertain, and movie studios had started allowing families to stream new movies in their homes. While I did some research and based my purchase on expectations of future earnings growth, this investment was quite speculative. In my wildest dreams, I could not have imagined the stock price would ever break $20. However, it did, and we took some profits. I fully realize that this was dumb luck.
But for every story of dumb luck prevailing, there are other stories with an opposite outcome. My father called me in 2009 and asked if it was a good idea to buy GM stock. GM was on the brink of bankruptcy. However, my dad believed it would receive a government bailout, and he could buy shares extremely cheaply. I told him it was not a good investment—it was a bet. He bought GM anyway. GM did go through bankruptcy and my father received pennies on the dollar from his investment.
These stories are far too common. Noted investor and father of value investing Benjamin Graham summed it up when he said,
“There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these, the foremost are: 1) speculating when you think you are investing, 2) speculating when you lack proper knowledge and skill, and 3) risking more money in speculation than you can afford to lose.”
One way to know if you are speculating is to ask yourself two questions. “At what price should the asset trade, and how did I arrive at that price?” An investor should be able to justify today’s price. “I expect the following cash flows to accrue to me in the coming years (rental payments, dividends, bond coupons, corporate earnings, terminal sales price, etc.) and for those cash flows which I expect in the future, I am willing to pay a price of X today.” As of this writing, the price of Bitcoin is around $33,000, down nearly 48% from the record high of April of this year. I recently heard an investor interviewed on CNBC make the case for Bitcoin trading for $75,000. I thought to myself, “Based on what? Why not $7,500? Why not $100,000? Why not $1 million? On what does one base the valuation?” The asset has no earnings, no future cash flows and at this point, very limited utility outside of dealing with criminals. Let’s face it, when I buy Bitcoin, I am hoping the price goes up. Please know that I am not saying that the price of Bitcoin won’t go up. Heck, it might go to $1 million. I don’t know. I’m simply distinguishing between speculating and investing.
In contrast to speculation, investing involves a rigorous process to acquire assets for the long term with the goal of generating income and building wealth for the future. At Bragg, we were deeply concerned about how the pandemic might impact stocks and bonds over the short term. However, we believe capitalism works over the long term. We believed that eventually, things would return to normal. Our philosophy has remained the same. We don’t presume to know what the market will do. We take great care to stay humble and control what we can. To invest effectively, there needs to be a process in place, and it must be followed in good times and bad times. The process must be consistent and disciplined, and followed unemotionally. We continued to rebalance accounts as the market dropped. Rebalancing allows us to buy stocks at low prices during bad markets and sell them at higher prices when the market improves.
At Bragg, our Investment Committee meets once a week to diligently review specific sectors and stocks. We analyze companies’ financial statements to determine whether each company’s stock is fairly valued, undervalued, or overvalued. We look for companies with strong fundamentals, a history of generating and growing their profits organically, and enough cash on hand to cover their debts. Companies with strong fundamentals will most likely be able to withstand cyclical business downturns. We want to own companies that we believe will thrive in good times and survive in bad times. Our goal is to own a diversified portfolio of high-quality companies that we feel comfortable holding on to for ten-plus years, unless circumstances change.
Human beings are emotional and social creatures. The glittering prospect of large profits through speculation on hot tips will always be attractive. But we at Bragg believe in a steady, disciplined investment process, and that is what we will continue to provide our clients.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.