Investment vs Speculation: Who Wins in the Long Run

 

This chapter will provide an outline of the ideas we will elaborate later in the book. Our intention at the outset is to develop a portfolio policy concept that is broadly applicable to the non-professional private investor.investment vs speculationWhat is meant by 'investor'? Throughout this book this term will be used in contrast to 'speculator'. As early as 1934 in our book Security Analysis, we tried to draw a clear distinction between the two, which was this: "Investment is that which by analysis is determined as to the safety of principal and the expected return. Speculation is that which does not require this."We stuck to this definition for the next 38 years, but it is worth discussing the radical changes that took place in the use of the word 'investor' during this period. After the great market crash of 1929-1932, all common stocks came to be regarded as largely speculative in nature (one leading authority explicitly stated that only bonds should be purchased for investment). So we then had to defend our definition against the charge that it had made the scope of investment too broad.Now we have a different concern. It saves our readers from accepting the 'common jargon' that labels anyone and everyone in the stock market as an 'investor'. In our last edition we quoted the following headline from the June, 1962 cover article of our popular Finance magazine:

Small investors are bearish and are involved in excessive short sellingIn October 1970, the same magazine published an editorial critical of the 'unwary investors' who were involved in the buying spree at that time.These quotes clearly illustrate the confusion that has dominated the use of the terms investment and speculation for many years. Consider our definition of investment above and then compare it to the sale of a few shares of a stock by an inexperienced member of society who has no idea what he is selling. This member believes, on a largely emotional basis, that he will be able to buy them back at a much lower price. (It is not out of place at this point to point out that when this article appeared in 1962, the market had already fallen sharply, and was now poised for a new spectacular rally. This was as bad a time as possible for short selling.) In a more general sense, the later use of the term 'careless investor' can sometimes be taken as a humorous oxymoron, similar to 'spendthrift miser', which is not a pun, but an abuse of language.The newspapers use the word 'investor' in this way because, in plain Wall Street parlance, anyone who buys or sells a security is an investor, no matter what or for what purpose, or whether he is buying at what price, or whether he is buying for cash or on margin. Compare this with the public's attitude toward common stocks in 1948, when 90% of those questioned opposed buying common stocks. Of those questioned, the reason cited was that it was 'unsafe' and a 'gamble', and the rest cited ignorance. It is ironic, of course, (though not surprising) that common-stock purchases of all kinds were generally regarded as highly speculative or risky to a large extent,

That too at a time when they were selling it at a very attractive rate, and the biggest rally in history was about to begin. On the contrary, the fact was that they had actually moved beyond what was clearly considered a dangerous level due to past experiences, which translated into investment, and all the stock buying public became investors.The distinction between speculative and speculative investment in common stocks has always been a useful one, and its disappearance is a cause for concern. We have often advised Wall Street as an institution to reestablish the distinction and insist on it in all its dealings with the public, lest the stock exchanges themselves some day be blamed for heavy losses from speculation for failing to give adequate warning to the victims. Ironically, once again, the recent financial troubles of some stock exchange firms were caused by their inclusion of speculative common stocks in their own equity funds. We trust that readers of this book will come away with a clear understanding of the inherent risks involved in common stocks. Risks that are inherently inherent in the opportunities for profit that they provide, and which the investor must factor into his calculations.What we have just said is an indication that there is no longer such a thing as a Simon-Pure investment policy involving representative ordinary shares - such that one could wait to buy them at a price without market risk or a 'quotation loss' large enough to cause distress.The investor must often be aware of the speculative factor in his stock holdings. It is his job to keep this factor to a minimum, and be financially and mentally prepared for the worst-case scenario, which could be short- or long-term.There should be two more paragraphs on stock speculation, because as is now well known, speculative components are inherent in most representative common stocks. Explicit speculation is neither illegal nor unethical, nor difficult (for most people) to learn. Moreover, some degree of speculation is necessary and unavoidable, since many common stocks have substantial potential for both profit and loss.

There are possibilities, and one must also imagine the risks involved. There is intelligent speculation, just like there is intelligent investing, but there are many ways in which speculation is not intelligent. Some of the most important are: (1) speculating while thinking it is an investment, (2) taking speculation seriously rather than as a joke despite not having the proper knowledge and skills, and (3) investing more money in speculation than one can afford to lose.In our conservative thinking every non-professional who is merely working on margin is speculating automatically, and it is the job of his broker to give him the right advice. And anyone who is buying the so-called, 'popular' common-stocks, or something like that, is either speculating or gambling. Speculation has always been tempting, and if you are adept at the game, it is very enjoyable. But if you want to try your luck, set aside some part of your capital, the less the better, for this purpose. Do not add more money to this account just because the market is rising and profits are increasing (this is the time to withdraw money from your speculation fund). Do not do your speculative and investment operations from the same account, do not think so.Defensive Investor's Outcome ExpectationsWe have already mentioned that a defensive investor is one who is primarily interested in safety and invests hassle-free. In general terms, which route should he take in 'average normal conditions' and what returns it will give?

What can he expect-if such a Salaat really exists? Before answering these questions we need to consider first what we wrote on the subject seven years ago, second, what important changes have taken place since then in the underlying factors governing the expected return on investment, and finally what he should do and what he can expect in the present circumstances (early 1972).1. What we said six years agoWe recommended that the investor split his holdings between high-grade bonds and leading common stocks, with the proportion of bonds being no less than 25% and no more than 75%, and the opposite would essentially be true for common stocks. His simplest option would be to maintain a 50-50 ratio between the two, balancing the ratio when market activity changes it by about 5%. As an alternative policy, he could choose to reduce his holding of common stocks to 25% if he felt the market was rising dangerously. And conversely, he could increase it to a maximum of 75% if he felt a decline in the price of the balances was making them extremely attractive.In 1965, investors could buy 4.5% high-grade taxable bonds and 3.5% good tax-paying bonds. This average return on leading common stocks (with a DJIA of 892) was only about 3.2%. This and other facts call for caution. We said that, in normal markets, an investor would be able to earn an initial dividend return on his shares of between 3.5% and 4.5%, to which should be added a steady increase in the underlying value of a representative stock index of about the same amount (and in a normal market trend). This would give a 7.5% annual return, including dividends and appreciation. A fair split between bonds and stocks would yield a return of about 6% before income taxes. We added that a reasonable level of protection in the stock component would be needed against the loss of purchasing power caused by rampant inflation.It should be pointed out that the above arithmetic implies an expectation of a very low rate of stock market flow, whereas much higher growth was achieved between 1949 and 1964. For listed stocks, this rate was spectacular. Their average gain was more than 10%. This was usually seen as a guarantee that similar satisfactory growth could be relied upon in the near future. Few were prepared to consider seriously the possibility that high rates of growth in the past meant that rates were much higher. And that the outlook after 1949 was not good for the future, but rather bad.

2. What has happened since 1964?The biggest change since 1964 has been the rise in interest rates on first-grade bonds to record highs, although they have recovered considerably from the 1970 lows. The yield on quality institutional stocks is now about 71226%, up from 41/2% in 1964. Meanwhile, the dividend yield on DJIA-type stocks continued to grow well during the market crash of 1969-70, but at the time of writing (when the Dow is at 900), it is less than 3.5%, compared with 3.2% at the end of 1964. The maximum market price drop for medium-term (say, 20-year) bonds during this period was about 38%, as a result of the changes in interest rates.This is the paradox of this progress. In 1964 we discussed at length the possibility that stock prices were probably too high and that this would eventually lead to a major decline, but we did not specifically consider the possibility that the same would happen to high-grade bonds. (Nor did anyone else we knew.) We warned that "long-term bond prices may vary considerably with changes in interest rates." In light of all that has happened since, this warning has been insufficiently emphasized - including the relevant examples - because the fact is that if the investor had held that amount in the DJIA at the 1964 closing price of 874, he would have had very little profit at the end of 1971. Even at the 1970 low (631), his notional loss would have been less than that of good long-term bonds. On the other hand, if he had restricted his bond-like investments to US savings bonds, short-term corporate issues, or savings accounts, he would have lost no market value of his principal during this period and would have earned a higher return than he would have received from a good shaver. Thus, he finds that in 1964 'cash equivalent' investments outperformed ordinary shares, even in the face of inflation, which in theory makes shares more liquid than cash. The fall in the quoted principal value of good long-term bonds was due to the dynamics of the money market, an obscure area which normally has no significant bearing on a person's investment policy.This is just one of an endless array of experiences over time that show that the price of securities cannot be predicted.

There is almost always much less volatility in bond prices than in stock prices. Investors can usually buy good bonds maturing in any time period without worrying much about changes in market value. There are some exceptions to this rule, as the period after 1964 proved. We will be talking more about bond price movements in the upcoming chapters.3. Expectations and policies in late 1971 and early 1972By the end of 1971 it was possible to earn 3% taxable interest on good medium-term corporate bonds, and 5.7% tax-free interest on good state and corporate securities. In the short-term sector, investors could earn about 6% on five-year US government issues. This second method did not require the buyer to worry about a possible appreciation in market value, since he was guaranteed to eventually get his money back, plus 60% interest, over a short-holding period. In 1971, the DJIA's 900 recurring price level yielded only 3.5%.Suppose we have to make a basic policy decision today, as before, about how to divide capital between high-grade chads (or other so-called liquid assets) and leading DJI A-type stocks. What course should we take in the present situation if we have no good reason to anticipate a big uptrend or a big downtrend in the near future? Suppose we estimate that, absent serious adverse changes, a defensive investor should expect a current 3.5% dividend return on his shares and an average annual growth of 3.5%. We will explain later that this growth is essentially a function of the amount of annual non-distributed profits of the various companies being redirected to their stocks. The combined return on the shares could average 7.5%, which is a function of the high-grade. On a pre-tax basis, the average return on the shares is 5.3%.

This is almost as much as one can get on a good tax-free medium-term bond.Today these expectations favour shares less than bonds than they did in the 1964 analysis. (This conclusion essentially follows from the basic fact that since 1964 the returns on bonds have been much higher than the returns on shares.) We must not forget that interest and principal payments on good bonds are more secure and therefore more certain than dividends and share price appreciation. At the same time, we are forced to conclude that today, at the end of 1971, bond investment is clearly preferable to share investment. If we are confident of this conclusion, we should advise the defensive investor to put all his money in bonds rather than ordinary shares, until there is a significant change in the current return relation in favour of shares.But of course, at today's level we cannot say with certainty that bonds will outperform stocks. Readers will immediately think of the inflation factor as a possible other factor. In the next chapter we will argue that our specific experience with US inflation does not support choosing stocks over bonds in this century, given current differences in returns, but there is always a possibility, although we consider it remote, that inflation may rise, which will in some way make stock equities better than bonds, which have fixed dollar payments. There is also the alternative possibility, which we consider highly unlikely, that US businesses will become so profitable, without inflation, as to justify a large increase in the value of ordinary stocks in the coming centuries. Finally, there are other known possibilities in which we could see excessively predictable increases in the underlying value of what is in the stock market. Investors may also be more likely to be interested in bonds for reasons not mentioned in our view.

Investing 100% may lead to regrets, even if the return level is favorable.So after this foregoing discussion of the more important considerations, we will return to the basic trade-off strategy that is in place for defensive investors—especially those who have put a large amount into one bond-type holding and a small amount into equities. It is still true that they can have a simple 30-50 split between the two components, or a ratio that suits them, with a minimum of 25% to a maximum of 75% difference between them. We will present our detailed views on these alternative strategies in the following chapters.Since the total return assumed by the principal investor from ordinary stakes is approximately the same as that from wands, the expected return (including the appreciation in the share price) for the principal investor is not much different regardless of how he divides his money between the two components. As per the above calculation, the average return from the two components could be 7.8% on a pre-tax basis or 5.5% on a tax-free basis (or after paying estimated taxes). The return from this arrangement would be higher than what a traditional conservative investor would have realized over the long term. This may seem unattractive compared to the approximately 14% return generated by the predominantly bull market over the 20 years since 1949, but it is important to remember that between 1949 and 1969 the DJIA more than quintupled in value while its earnings and dividends doubled. Thus the impressive market record during that period was due primarily to a change in the mindset of investors and speculators, not to their own growth. Fundamental corporate values. It could also be described as a 'bootstrap operation' to some extent.In looking at the strategic investor's common stock portfolio, we have looked only at the key issues that are among the 30 components of the Dow Jones Industrial Average. We have done so only as a point of view, and this is not to say that Devan Che is capable of buying any of the 30 issues. In fact, there are many other companies whose quality is equal to or better than the average of the companies listed in the Dow Jones. This includes public utility companies (which are considered to be the Dow Jones average components). But the main point here is that The defensive investor's overall results should not differ significantly from those of any other representative or specialized list, or it would be more accurate to say that neither he nor his advisers can predict with certainty how much they will ultimately differ. While it is true that the art of smart investing lies in the selection of particular issues that produce returns that are superior to those of the general market, we remain skeptical of the defensive investor's ability to achieve above-average results that would, in effect, undermine his overall performance. (Our skepticism also extends to the management of book funds by specialists.)We illustrate our point by giving an example that at first glance seems to be the opposite. Between December 1960 and December 1970 the DJIA rose from 616 to 839, or 36%, but during the same period the much larger Standard & Poor's 500-stock index rose from 58.11 to 92.15, or 58%. Clearly the second group was a better buy than the first, but who in 1960 would have been so audacious as to predict that what appeared to be a variety of classifications of all types of ordinary stocks would accurately outperform the Dow's "grand thirty dictators"? We assert that this proves that few people can reliably forecast price changes, either absolute or relative.We repeat without hesitation that the warning cannot be overemphasized that investors should not expect better than average results when buying new, or however "hot," issues, i.e., those that are recommended for immediate profits. In the long run, the opposite is almost certain to happen. The defensive investor should limit himself to stocks of important companies with a long track record of profitable operations on solid financials. (Any securities analyst who is adept at his job can make such a list.)

Aggressive investors can also buy other types of ordinary shares, but they too must have attractive fundamentals based on intelligent analysis.In closing this section, we would like to briefly mention three helpful concepts or practices of the defensive investor. First, buying shares of well-organized investment funds as an alternative to building his common-stock portfolio. He can also use a common trust fund or a group of cormised funds, which are operated by trust companies and banks in many states, or, if he has the means, use the services of an accredited investment advisory firm. This will give him professional management with a standard line on his investment program. Third, the tool is dollar-cost averaging, which simply means that one invests the same number of dollars each month or each quarter in common stocks. In this way, he will buy more stocks when the market is down than when it is up, and in the end he will get a satisfactory total return on all his holdings. In fact, this is the basis for a broader approach called formula investing. We have already mentioned this in our recommendation that investors diversify their common shares to a minimum of 25% to a maximum of 75%, in order to maintain an inverse relationship with market movements. These considerations are important for defensive investors, and will be discussed in detail in the following chapters."How does an aggressive investor expect results?Of course, our enterprising securities buyer may hope to get better results than his more cautious or quieter counterparts, but he must first make sure that he does not get worse results. It is not uncommon on Wall Street to end up with losses instead of profits, despite all the energy, study, and efficiency one can muster. These qualities, if channeled in the wrong direction, are indistinguishable from inefficiencies. It is therefore essential that the enterprising investor begin with a clear idea of which system is more likely to succeed in a logical manner, and which is not.

First, we need to consider some of the ways that investors and speculators commonly attempt to achieve better-than-average results. These include:1. Trading in the market generally means buying shares in the market when it is rising and selling them when it is falling. The balances chosen have a better 'stance' than the market average. A small number of investors are constantly engaged in short selling. Here they sell issues which they do not currently own but have borrowed through the established mechanism of the stock exchanges. Their aim is to profit from a fall in the price of these issues. They do this by buying them at a price lower than the price at which they sold them. (As our quote in the Wall Street Journal on p. 19 indicates, 'small investors' sometimes try their unskilled hand at short selling without giving too much meaning to the term).2. Short-term selectivity This means buying shares of companies that are reporting or expected to report rising earnings, or that are expected to have some favorable conditions.3. Long-term selectivity This usually emphasizes an impressive record of growth in the past, which is likely to continue in the future. In some cases the 'investor' himself selects companies that may not have shown impressive results yet, but are likely to establish high earnings power later. (Such companies are often found in a technical field, e.g. computers, medicine, electronics, and are often developing new processes or products that are considered particularly promising.)We have already expressed our negative view towards the investor's chances of complete success in these areas of activity. First of all, we reject these investment areas on both theoretical and practical grounds. "Share trading is not an operation which provides safety of principal and satisfactory returns on the basis of analysis. More about share trading is explained in the upcoming chapters."In trying to find the most promising short or long term stocks, an investor faces two kinds of obstacles. First, the human resource Fallibility and the nature of the self. He may be wrong in predicting the future, and even if he is right, current market prices will already reflect what he predicted. In the area of short-term criticality, a company's current year results are usually known to everyone on Wall Street. Next year's results are, to a large extent, predictable, and are already being given a lot of thought. So an investor who is picking an issue based on this year's best results, or what he has been led to expect for next year, is likely to be doing the same for the same reasons as everyone else.The dilemmas facing investors when selecting stocks for their long-term prospects are basically the same. The obvious possibility of forecast error-as we have shown in our airline example-is certainly greater when trying to make short-term gains, because experts tend to be misled in making such predictions. It would theoretically be possible for an investor to profit by making a correct forecast when the rest of Wall Street is guessing wrong, but that would only be theoretical. How many enterprising investors can rely on the wit or have the gift of prediction to beat professional analysts at their favorite game of guessing long-term futures?Thus, we can come to the logical and counterintuitive conclusion that to enjoy a reasonable chance of consistently delivering above-average results, an investor must adhere to two strategies: (1) be fundamentally strong and promising and (2) not be popular on Wall Street.Are there any such policies for the enterprising investor? Again, theoretically, the answer is yes, and there is good reason to believe that if it were actually done, the answer would be positive. Everyone knows that in the ordinary market speculative stock prices frequently move far in either direction. This happens all the time, at least in single issues. Moreover, an ordinary share may be undervalued due to lack of interest or unjust prevailing prejudice. If we go further, we will find that most people who trade in ordinary shares will not be able to distinguish one framework from the other. In this book we will give many examples (from the past) that will demonstrate discrepancies between price and price. Thus, it seems that for any intelligent person who is good at calculation, Ball Street is a picnic, where he has to be amused by the stupidity of other people. Well, it may seem so, but somehow it is not so simple. Buying an overlooked and therefore undervalued shaper for profits It is a long and varied experience. And in short that popular shaper may be called Beynaati Oshashvaityu, it is not only a test of a person's courage and endurance, but it also measures the depth of the pocketbook of power. This principle is solid, its complete application is not impossible, but it is not easy to master this art.There are also many special circumstances in which it can take years to generate 20% or better annual returns with minimal risk for those who know how to do it. They include security arbitrage, payment or liquidity estimation, special types of security hedges. The most common of these is a proposed acquisition in which the value of the shares is much higher than the date of their announcement. The number of such deals has increased a lot in the last few years, and this should have been a very profitable time for the investors, but with so many merger announcements, there have been many impasses in the mergers which sometimes lead to the deal not getting completed. Thus, even in such trusted operations, individuals have suffered losses. In addition, the rate of multiplication has also decreased due to the increased competition.Under these specific circumstances, the decline of profits appears to be a process of self-destruction, akin to the law of diminishing returns that I developed during the course of writing this book. The stock market fluctuations of 1949 could produce a study that supported a formula. Based on your own and current rates, DI isA level could be set to buy below the 'central' or 'intrinsic value' and sell above such a value. Here Robschild's motto 'buy cheap and sell cheap' was used. And this had the advantage that it was in direct contradiction to the Ball Street motto that stocks should be bought when prices are rising and sold as they are falling. Eventually, this formula became useless after 1949. Another example was the famous 'Dow Purely' about market dynamics, which showed excellent results between 1897-1933 for comparison and its performance was under question from 1934 onwards.The third and final example of precious opportunities not being available now: Our own operations on Wall Street were focused on buying up fake issues which could only be identified by the fact that they were being sold for less than their net working capital, without regard to plant accounts and other assets, and after first deducting all liabilities from the shares. It was obvious that these issues, being privately owned, were being sold at far below industry prices. No owner or majority holder would ever think of divvying up his balances at such an unusually low price, but strangely enough, such anomalies are not hard to find. In 1957, a list appeared in the market showing about 200 such issues. In practice, those cheap issues proved profitable in various ways, and their average annual returns proved more profitable than most other investment options, but in the next decade the reliable, shrewd and fast operating circle of enterprising investors also disappeared from the stock market. Then, in 1970, again a low share was seen.

 But such 'sub-working capital issues' appeared in large numbers, and even after a major recovery in the market, there were enough issues remaining by the end of the year to build a complete portfolio.There are a variety of opportunities for the enterprising investor to obtain better-than-average results in today's environment. The long list of marketable securities should include a number of stocks that can be considered undervalued on a reasonable and reasonably reliable scale. These may produce more satisfactory results than the average DJIA or some other such representative list. In our view, seeking them out is futile if it does not allow an investor to expect an average annual pre-tax return of more than about 5% on the stock portion of his portfolio. We must also seek to develop other approaches that the active investor can use in stock selection.