Speculation and Investment: Communicating the Differences in Style
Editor’s note: This is another response to the question posed here last week: what is the difference between investing and speculation? If you are compelled, we invite you to comment below, tweet us @cfainvestored, or reach out to us via email.
How do speculation and investment differ? Meanings of the terms in the professional money management industry reflect popular usage.
Outside of the industry, the term “investment” communicates a sense of clarity or at least commitment: Someone is invested in a particular point of view. Likewise, the industry has come to view investing as applying a rigorous analysis that offers some level of certainty. Determining the value of an asset or a stream of future cash flows and basing buy and sell decisions strictly on the basis of these calculations has long been the domain of value investors.
The term “speculation” suggests uncertainty, a guess, or even a gamble. In our profession, the term is often used to describe leveraged transactions or investment decisions based purely on the direction and momentum of prices. Speculation has often been derided by some of the most-respected members of our community. Benjamin Graham is attributed as saying, “The typical experience of the speculator is one of temporary profit and ultimate loss.”1
I’m merely stating the obvious when I say these terms have generally accepted meanings. Of course, the distinctions between the two terms within our industry are far from self-evident. Several approaches have been suggested to define the distinctions. Three worth considering are using (1) price history as the primary decision criteria, (2) the initial expected time horizon for holding an asset, and (3) whether leverage is involved. Unfortunately, none are useful in clarifying the distinction between investments and speculations.
Using price charts to make buy and sell decisions is generally considered the speculators’ domain. But investors who use price movements in the investment decision-making process aren’t necessarily speculators. For example, some money managers use valuations to make buy decisions and may include stop-losses in their sell decisions. In the 1973 movie Magnum Force, Clint Eastwood’s character, Harry Callahan, declared “A man has got to know his limitations.” As a risk management tool, stop-losses might help prevent severe losses if there is a mistake in an analysis or if an original investment thesis changes. If investors use stop-losses, they are using price history in their decision-making processes.
Investors are generally thought to have longer-term time horizons, but speculators can have long time horizons, too. Some trend-following techniques that most people would classify as speculative are quite long-term oriented.
A case can be made that some short-term traders are investors. Although day trading and high-frequency trading are generally considered speculative by the public, some disciplined day traders rigorously back test their strategies, which are designed to achieve safety of principal and a satisfactory return.
Time horizon doesn’t differentiate speculators from investors.
Most people accept that using leverage in a portfolio is speculative because it increases risk. Bridgewater Associates, the world’s largest hedge fund firm, asserts that using leverage can reduce risk. The firm’s All Weather investment strategy has earned about 10% annually over the past 10 years, soundly beating the 6% median annual return for all pension funds. Founder Ray Dalio recently said, “Ironically, by increasing your risk in the bonds, you are going to lower your risk in your overall portfolio.” If Bridgewater can add leverage to decrease risk, then using leverage might not be a suitable dividing line between investors and speculators, either.
Other terms like “momentum” and “mean reversion” can likewise be shown to be ineffective differentiators between speculation and investing.
Where Is the “There” There?
Gertrude Stein famously quipped, “There is no ‘there’ there,” describing a place lacking real meaning or soul. Likewise, “speculating” and “investing” are simply not satisfying descriptors for the nuances in investing styles that have developed over the years. They are too broad to have much real meaning.
Perhaps what we need are more terms to describe the risks in different investment techniques. After all, Eskimos have many words for “snow.” The term “intelligent speculation” has promise in this regard. But even if more terms are coined, we might be challenged to keep up with the growth in new investment techniques.
Using investment style to describe return drivers may be a better way to communicate the risk profile of a strategy. One tool advisers can use with clients to illustrate how various strategies have produced different results is on the American Association of Individual Investors (AAII) website. The AAII tracks 65 different investment strategies, organized by investment style, such as value, growth, price momentum, and insider buying. The AAII defines rules for each strategy and calculates monthly results for each. Of course, the strategies are really paper portfolios, so they are “executed” flawlessly and exclude transaction costs. Despite the flaws, this presentation shows how widely returns can deviate from established benchmarks based on style.
It may take time before we are able to use the terms “investing” and “speculation” with precision to describe the merits of various investment strategies. In the meantime, improving our descriptions of investment styles might be a more effective approach.
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1. The complete quote is, “Speculators often prosper through ignorance; it is a cliché that in a roaring bull market knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss.”
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