Welcome to Edelweiss Capital Research! If you’re new here, join us to receive investment analyses in 10 slides, economic pills and investing frameworks by subscribing below:
Just this week my girlfriend told me:
I don’t understand it. The way you invest is very different. There are many who invest and achieve great returns in a very short time. Your style doesn’t work at the beginning. You buy when things fall and you don’t care.
There are many frameworks out there trying to explain the difference between investing and speculating. Investing is seen as a noble activity whereas speculating is considered a dreadful act. Here we will set a clear and new applicable framework. Afterwards, we will dignify and put in value the art of speculation as a mean to make markets more efficient. Lastly, we will explain why what is considered as traditional (Benjamin Graham’s style) value investing, is nothing different than speculating.
An eternal and irrelevant debate
“The line separating investment and speculation is never bright and clear” (Buffett, 2001)
I have long been trying to find a framework to set a clear border between investing and speculation.
I could feel the difference, but I was not able to set clear boundaries. At first, I considered the work behind a decision as a relevant topic, but it was obviously not a plausible explanation. World-class level speculators (Soros, Akcman, Drunkenmiller, …) made deep analyses on any of their positions. That was not it.
Another common framework states that the main difference between speculating and investing is the amount of risk involved. While investors try to generate a satisfactory return on their capital by taking on an average or below-average amount of risk, speculators are seeking to make abnormally high returns from bets that can go one way or the other. Since I consider risk (nothing to do with volatility) a subjective parameter (one can reduce risk with a sound analysis), this definition simply doesn't work for me.
It was while reading The Zurich Axioms, a little old classic from the 70s, when it struck me. Max Gunther considers every current decision based on future outcomes as simple speculation and hence, for him there is not such a thing as investing (Gunther, 1972).
“There are simply too many unknowable variables involved to allow for trustworthy forecasts. Inflation rate, for example, is caused by millions of people making billions of decisions: workers about wages they want to be paid, bosses about wages they are willing to pay, consumers about prices they will swallow, everybody about diffuse feelings of hardship or prosperity, fear or security, discontent or buoyancy. To claim you can make reliable forecasts about this staggering complexity seems arrogant to the point of being ridiculous.”
This is absolutely true. There is uncertainty in every investing/speculation decision. Was Gunther right about there was not such a thing as investing?
This is when I realised the difference between investing and speculating was not in the certainty of the outcome. I was looking in the wrong place. Both are uncertain!
The difference lies in the purpose.
Speculation is the process of buying something with the idea to sell it later at a higher price (lower if you short or you buy some puts). Investing is, however, different.
Investing means buying a company with the mindset of becoming the owner. Your intention is not to sell it. Your goal is to enjoy the ride and participate in the future benefits of being an owner.
Under this approach, things become more clear and easy to define.
Speculators help making markets efficient
In general, speculators are often frowned upon by society and regulators alike for the volatility they create in the market. But speculators are just another wonderful mechanism of free markets for stabilising prices. They just serve as a resort for further interaction between individuals with different time expectations and valuations. They provide liquidity to the markets.
But this is not everything. Along history, speculators have busted companies and governments alike, dismounting frauds that otherwise, will have continued growing with worse future consequences and generating further market inefficiencies.
A remarkable example is George Soros’ attack on the British pound some decades ago. To boost the economy, the UK had to cut interest rates which would devalue the pound. To keep the value of the Pound stable, the central bank had to buy Pounds using their foreign reserves while trying to artificially keep the Pound afloat.
Amidst these politically inspired economic decisions, George Soros spotted the fault lines in the system and realised how unsustainable it was. What happened is history. But the key take-away is how speculators also bring efficiency to markets, discovering and imploding money-making schemes, bubbles and frauds.
Value investing speculating
You might have realised that under this framework, I consider “classical” value investors as mere speculators. Before you stop reading, let me clarify. I refer to those buying a business just because the stock price is undervalued, with the intention to sell it once it reaches their intrinsic price. No matter if it takes 2 months or 5 years, but they are acting as mere arbitrageurs in the price-formation of the market. It is a noble activity and it makes markets more efficient, but the goal is to sell it afterwards. Therefore, the parameters considered to take an arbitrage decision are different from the investing decision-making process. Business culture, management qualities and ROIC will be less important if the price of the shares are highly undervalued if you plan to sell them as soon as it reaches your goal.
On the other hand, we encounter a second group of value investors. Those identified with the second of Buffett’s investing periods, when he stopped buying cigar buts to focus on long-term holdings and fair prices.
“Buffett and Munger doubted that they could have done better trying to dance in and out. For one thing, a buy-and-hold investor put out the tax man-over time, a very big saving. For another, their long term approach created opportunities: a Mrs. B or Ralph Schey was more inclined to sell to an owner such as Buffett. And, knowing the divorce was not an option, Buffett was a bit--quite a bit--more circumspect in choosing a partner. To the extent that he, or any investor, is not thinking about how and when he will get out, he will be more selective on the way in. As in a marriage, this is apt to lead to better results.” (Lowenstein, 1995)
I feel many times ashamed for using so many Buffett’s quotes, but he has the virtue of explaining things bright and clear:
Wrapping up
Note that the three different methodologies discussed here today create value for society. They are all necessary to create prices and markets and hence, one can build wealth using any of them. They are simply different things and the mental frameworks and tools they require are just different. You must reflect which ones of them adapt better to your personality, expectations and time frame.
Lastly, let me share with you this video dated from 2019 explaining how these two great investors, Bruce Flatt and Howard Marks approach the philosophy of investing. Worth watching.
If you enjoyed this piece, please give it a like, subscribe and share!
Thanks for reading Edelweiss Capital Research! Subscribe for free to receive new posts and support our work.
If you want to stay in touch with more frequent economic/investing related content, give us a follow on twitter @Edelweiss_Cap. We are happy to receive suggestions on how we can improve our work.
References:
Buffett, W. (2001). Berkshire Hathaway annual letter to shareholders 2000. https://www.berkshirehathaway.com/letters/2000pdf.pdf
Gunther, M. 1972. The Zurich Axioms: the rules of risk and reward used by generations of Swiss bankers. Harriman House. UK
Lowenstein, R. 1995. Buffett: the making of an American capitalist. Random House. NY