Speculation vs. Investment

"An investment operation is one which, upon thorough analysis, promises safety of principle and a satisfactory return. Operations not meeting these requirements are speculative.... An investment operation is one that can be justified on both qualitative and quantitative grounds." Security Analysis, Graham & Dodd, 1951 Edition

Defining the term investment is somewhat difficult as most people have their own understanding of what it means to invest their money. As a simple example, we probably can all agree that investing £50,000 in a business and subsequently receiving an annual income from the business of £10,000 can be classed as an investment. In the world of financial markets the definition of an investment is not as clear cut. It is quite clear that there is often no real distinction between speculation and investment in this arena.

Generally speaking, speculation could be defined as bad and investment could be defined as good. When looking at these definition in such simple terms the distinction between the two becomes far more obvious. However in financial markets how can we tell what is good and what is bad? Before going any further, it would be fair to say that before an investor starts to invest his money this is a distinction that should be clearly understood. In any case, the failure of investors to understand this difference is what caused the disastrous dot com mania and its subsequent crash.

Keep in mind that just because a security may be seen as low risk does not mean that it is not possible to speculate. For example, on one hand take the large purchase of a particular bond issue in anticipation of a quick rise in price. This speculative behaviour turns an otherwise "safe" investment into something more risky. On the other hand, just because a security is perceived as a higher risk does not mean that it can not be classed as an investment. Take for instance the purchase of a relatively smaller cap stock trading at below its intrinsic value. The very fact that the stock trades below its calculated intrinsic value creates a price buffer, associated with the purchase at that price. This price buffer is otherwise known as a margin of safety and serves to somewhat protect the investor against large losses associated with the purchase.

It is this margin of safety that offers an indication to the definition of what could be termed as an investment. Using the two previous examples, this concept can only really be useful when the purchase of a security is done using more than psychological factors. What is needed in the purchase of an investment is a set of repeatable standards that can assist the investor gauge the amount of safety associated any given opportunity. It is important to realise that for any given security, the purchase may be classed as an investment at one price but not at another. Again, understanding the margin of safety principle makes this obvious.

Although not investments, a basic everyday analogy is the purchase of an article of clothing in the week before Christmas compared to the week after Christmas when the sales are on. We are paying two completely different prices for exactly the same product. This shows that when the price is right we obviously get better value for our money. Investing is no different. It's all about buying at the right price.

Determining the investment worth of any given security is not a precise science. Moreover, it is something that, even with careful analysis, is different for every situation. It will however still offer reasonable protection against loss under all "likely" conditions. What is important is that the definition of the process that is used determine the real worth of a security, and whether to go ahead with the investment, is backed up with a well defined yet flexible valuation strategy. Taking into account the price and the quality of security is all part of this strategy.

As the level of chance in a given investment increases, the value of analysis starts to decrease. One of the underlying problems with speculative investments is that they are susceptible to sudden price corrections. Even though the intrinsic value of an investment of less speculation can change before it is reflected in the market price, this problem becomes even more pronounced as an investment becomes more speculative.

To quote Graham and Dodd's 1951 edition of Security Analysis, investments can be broken down into four different types:

1. Business investment - Referring to money held in a business.
2. Financial investment or investments generally - Referring to securities generally.
3. Sheltered investment - Referring to securities regarded as subject to small risk by reason of their prior claim on earnings or because they rest upon adequate taxing power.
   
4. Analyst's investment - Referring to operations that, upon thorough study, promise safety of principal and an adequate return.

Additionally, to quote Security Analysis further, speculations can be broken down into two types:

1. Intelligent speculation - the taking of a risk that appears justified after careful weighing of the pros and cons.
   
2. Unintelligent speculation - risk taking without adequate study of the situation.

This break down offers a simple description of the differences between the various types of investments and speculations. Clearly the two forms of speculation
are very different and I think that it should be immediate that the second form could be likened to gambling. When investing, we would ultimately be aiming to ensure that the investments that we do make fall under the category of being analyst's investments. Otherwise, money not held under this category could arguably be classed as one of the two forms of speculation.