Investor Vs. Speculator: Which Are You?

A huge misnomer is that anyone holding stocks or bonds is an “investor.” In fact is that this couldn’t be further from the truth! In this assumption, we must first attempt to define investing and speculating. According the Benjamin Graham, “An investment operation is one, which upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting those requirements are speculative.” (The Intelligent Investor, 1973 ed. Updated and revised in 2003, pg. 18). Who was Benjamin Graham and why should we listen to what he has to say? Ben Graham was not only one of the most successful and famous investors who ever lived, he may have also been the most practical investment thinker of all time and is often referred to as the “father of value investing.” Graham’s students and protégés include some of the most famous investors of all time - Warren Buffett, Charlie Munger, Walter Schloss, Tom Knapp and Ed Anderson (who ran Tweedy, Browne Partners from 1968-1983), Bill Ruane (who ran Sequoia Fund from 1970-1984), Rick Guerin, and Stan Perlameter. You may not recognize all of these names, but each learned (some in formal classrooms) from Ben Graham and achieved astounding and consistent investment records following and applying Graham’s investing philosophies.

In Graham’s definition of investing we find that by (1) “thorough analysis” he meant “the study of facts in the light of established standards of safety and value”; (2) “safety of principal” he meant “protection against loss under all normal or reasonably likely conditions or variations”; and (3) “adequate return” he meant “any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.” (Security Analysis, 1934 ed. pg. 55-56).

According to Graham (in 1973) Wall Street with the millions of advertising dollars, “would be well advised to reinstate this distinction and to emphasize it in all its dealings with the public. Otherwise, the stock exchanges may some day be blamed for heavy speculative losses, which those who suffered them had not been properly warned against.” How prophetic! Graham, through his truthful and thoughtful discourse, is prophetic time and time again in his writings. Remember the bursting of the tech bubble and the lawsuits that followed? Terms such as “reckless investing or investor” is thrown about, when in fact the two words are completely contradictory. There is no such thing as a “reckless investor.”

An investor buys a stock based on the value of the underlying business compared to its current price while a speculator gambles on a stock believing it will go up in price because someone else will pay more for it. Unfortunately, many so called “professionals” in the money management business don’t seem to understand the difference between investing and speculation any more than the average investor. For example, Jason Zweig (The Intelligent Investor, pg. 16) cites a quote from James Cramer in February 2000 who proclaimed that Internet-related companies “…are the only ones worth owning right now.” Cramer goes on to say that these “…winners of the new world are the only ones that are going higher consistently in good days and bad.” Cramer even took at shot at Graham when he said: “You have to throw out all the matrices and formulas and texts that existed before the Web….If we used any of what Graham and Dodd teach us, we wouldn’t have a dime under management.” Think Cramer regrets those comments today?

Do note, however, that there is intelligent speculation just as there is intelligent investing. However, Graham tells us that there are many ways in which speculation may not be intelligent; namely (1) speculating when you think you’re investing; (2) speculating seriously instead of as a pastime when you lack proper knowledge or skill for it; and (3) risking more money in speculation than you can afford to lose. Of course speculation is critical to the functioning and growth of the US economy as it allows untested companies the ability to raise capital and expand (one reason the US is such a world economic power is the efficiency in our capital raising systems) and it serves as a medium for the exchange of risk.

The crux of the matter then; if you invest in individual stocks, do you know the intimate details of each company? Do you understand the business and the business model? Do you know all of the company’s current and historical fundamentals? Do you know why it appears to be undervalued? Do you know the fair value at which you would sell the proposed stock? Without knowing all of these details (any many more), you are speculating, not investing. And that is a dangerous game to play.