“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” –Benjamin Graham
In the first part of this series on value investing, I looked at the origins of value investing, and how Benjamin Graham, who is widely considered to be the Godfather of value investing, compiled the strategy at a time when the rest of the investment world was obsessed with speculating on asset prices.
At this stage, I feel it is essential to clarify further the difference between investment and speculation. Understanding the difference between the two is critical for long-term investment success. If you know the difference between investment and speculation, you can tailor your investment strategy accordingly.
Unfortunately, trying to define the difference between investment and speculation is not easy. There is a grey area between the two. However, broadly speaking, investing can be described as buying a stream of cash flows. Whereas a speculative trade is a trade where the buyer/seller is hoping for nothing more than for the price of the asset to increase.
A rough example: Buying a property hoping the price will go up and you can sell it in two years time for more than you bought it is speculating. On the other hand, if you buy the property as a rental investment, then it will qualify as an investment.
The same investment/speculation blueprint is accurate for equity investors. If you buy a stock hoping the price will go up, without any consideration of the underlying cash flows of the business, then it is speculating. If you buy a stock based on a detailed analysis of its fundamentals and cash flow projections, then it can qualify as an investment.
It was the detailed analysis of a company’s underlying fundamentals that Benjamin Graham defined as value investing. This remains the core of the strategy today.
Another definition of investment and speculation, which helps segregate the two investment disciplines further, is provided by Investopedia.com. The site notes that the level of risk taken in a particular trade is another deciding factor. Typically, high-risk trades (akin to gambling) fall under the speculation banner, while lower risk deals, which are based on detailed fundamental analysis and, as noted above, cash-flow analysis, fall under the investment umbrella.
It is not easy to precisely define the difference between investment and speculation, but a broad understanding of the two can help improve your investing process. Investing involves buying a stream of cash flows from a business, and as a result, tends to come with less risk. Meanwhile, speculating involves more guesswork and more risk/uncertainty.
If you’re not sure if you are investing or speculating, ask yourself “what percentage of this company’s profits do I own and where is this profit coming from?” If you can’t answer these two simple questions regarding the fundamentals of the business, then you’re probably speculating.