My views on the market, tech, and everything else

Investment vs. Speculation

Jason Zweig makes an interesting point about the difference between investment and speculation. http://blogs.wsj.com/totalreturn/2013/02/28/are-you-an-investor-or-a-speculator-part-one/?mod=WSJ_Business_LatestHeadlines He raises the idea that the distinction should perhaps have a time element, which in my view is not helpful.

Seth Klarman has written:

“The line I draw in the sand is that if an asset has cash flow or the likelihood of cash flow in the near term and is not purely dependent on what a future buyer might pay, then it’s an investment.  If an asset’s value is totally dependent on the amount a future buyer might pay, then its purchase is speculation.”

The key element in this definition is that investing as opposed to speculation does not involve trying to predict the behavior of others:

“Stock speculation is largely a matter of A trying to decide what B, C and D are likely to think-with B, C and D trying to do the same.”  Benjamin Graham

If your game is forecasting market psychology you are not an investor.  Keynes wrote that speculation is

“the activity of forecasting the psychology of the market . . . attaching hopes to a favorable change in the conventional basis of valuation.”

To buy gold is to speculate says Howard Marks:

“There is nothing intelligent to be said about gold. Nobody can tell you the right price for an ounce of gold. People will tell you it should go up or go down. To make any intelligent statements about investments you have to know what the right price is. You can’t do that with an asset like gold, which doesn’t produce any cash flow. So you can buy it out of superstition or ignore it because you are an atheist but you cannot buy it with an analytical foundation.”

While you can make a profit via speculation in gold or a baseball card, it is not investing.

Klarman gives no indication that he believes merger, risk or statistical arbitrage can’t be investing just because the duration of the investment may be short.

“Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months. An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one’s initial investment returned to cash, one’s profits are as well.” [Emphasis added]

That what Graham calls “an operation” may have a short time duration is a warning sign that it may be speculation, but it is not a barrier to it being an investment.  Arbitrage can involve risk but it Is not dependent on a forecast of market psychology but rather on something like whether the transaction will be completed.

Klarman again:

“…assets and securities can often be characterized as either investments or speculations.  The distinction is not clear to most people.  Both investments and speculations can be bought and sold.  Both typically fluctuate in price and can thus appear to generate investment returns.  But there is one crucial difference: investments throw off cash flow for the benefit of the owners; speculations do not.  The return to the owners of speculations depends exclusively on the vagaries of the resale market.

The greedy tendency to want to own anything that has recently been rising in price lures many people into purchasing speculations.  Stocks and bonds go up and down in price, as do Monets and Mickey Mantle rookie cards, but there should be no confusion as to which are the true investments…

Investments, even very long-term investments like newly planted timber properties, will eventually throw off cash flow.  A machine makes widgets that are marketed, a building is occupied by tenants who pay rent, and trees on a timber property are eventually harvested and sold.  By contract, collectibles [and precious metals I might add] throw off no cash flow; the only cash they can generate is from their eventual sale.  The future buyer is likewise dependent on his or her own prospects for resale.”

“… Risk arbitrage is a highly specialized area of value investing. Arbitrage is a riskless transaction that generates profits from temporary pricing inefficiencies between markets. Risk arbitrage, however, involves investing in far from riskless takeover transactions. Spin offs, liquidations, and corporate restructures, which are sometimes referred to as long-term arbitrage, also fall into this category. Profit or loss depends much on the successful completion of a business transaction.”

“…Opportunity exists in part because the complexity of the required analysis limits the number of capable participants. Further, risk arbitrage investments which offer returns that generally are unrelated to the performance of the overall market, are incompatible with the goals of relative-performance-oriented investors. Since the great majority of investors avoid risk arbitrage investing, there is a significant likelihood that attractive returns will be attainable for the handful who are able and willing to preserve.”


“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

“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.”

“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.”

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