Investing vs. Speculating

This commentary is still a work in progress, but the concept merits further consideration.

For the average American who places his hard-earned money in the stock market, there is no differentiation between investment and speculation. But the two terms are not interchangeable. And the lack of knowledge about the differences between investment and speculation is invariably harmful, both to individuals and businesses. The best way to define the differences between investing and speculation is to clarify the motivations and actions of the parties in a stock transaction.

When an individual investor buys stock directly from the company, the motivations and actions of both parties are directly connected. The investor receives a fractional interest in the company, with the right to a proportionate share of the company’s profits. In exchange for selling a percentage of ownership, the company receives capital to further its business plan.

In this transaction, each party is offering and receiving value directly from the other. The investor offers capital to the company and receives ownership from it. The company offers ownership to the investor, and receives his capital.

But what happens when an investor sells his ownership to another party? An exchange of value occurs, as one receives capital and the other receives the ownership interest. But this transaction, while it involves the company’s stock, does not create a material change for the company, at least from a financial standpoint. The company receives no new capital from this transaction. The company is a focus of the transaction, but not part of it.

Even if the investment is profitable, there can be legitimate reasons for the first investor to sell his ownership interest in the company – there may be a need for capital, the desire to pursue other investments, etc.

Unlike the first investor, the second buyer is not considering the viability of the company as much as he is assessing the market value of the first investor’s shares. The company may be an under-performer, but if the shares can be purchased at deep discount, even a poorly-performing business can provide a satisfactory return. Further, if there is the prospect that the stock value will rise sometime in the future, the second owner can sell his interest at a premium.

I characterize the first transaction as investment, and the second as speculation. In investment, the critical evaluation for the prospective stock buyer is the collective merits of the company. In speculation, the critical evaluation is whether the value of ownership is fairly priced – and whether one can capitalize on a discounted price.

I do not see either investing or speculation and immoral or wrong activities. But I am of the opinion that the knowledge required for speculation is much greater and much harder for the average individual to acquire and assess.

Using my definition, most of what are characterized by the financial institutions as “investments” are really exercises in speculation. A buyer in the secondary stock market (i.e., non-IPO purchases) isn’t buying the company as much as he is buying the perceived pricing opportunity. That’s why a broker tells a client “this stock is under-valued.” The determination of whether a stock is over- or under-priced is subjective. The only factual pricing of a stock is the price of the last transaction. But all secondary buying hinges on the belief and hope that the price will go up in the future (or down, if one is selling short).

The processes used by stock analysts to predict future pricing are complex and arcane, and no process is considered definitive – new ones are developed all the time. In this format of overwhelming and incomprehensible information, the average consumer has no chance at formulating an independent intelligent decision. He is at the mercy of the “experts” selling him on the stock, and their expertise cannot be separated from their financial incentives to make sales. Placed at such a disadvantage, it’s not likely that a profitable decision will result. And in fact, statistical studies of actual investor performance bear this out (for an example, see dalbar.com).

Knowing that most investment is closer to speculation, it’s reasonable to question whether most American consumers should even want to play the game. Historically, you can make a good argument that minimizing debt and maximizing saving in guaranteed vehicles (CDs, bonds, life insurance cash values) is a much better strategy for achieving financial success and stability.