This article on The Intelligent Investor was written by Colin Richardson. Colin is a private investor based in Alberta, Canada. He focuses on applying a quantitative strategy to eliminate behavioral biases in his personal account. Article image (Creative Commons) by CreditDebitpro, edited by The Broken Leg.
Are you an intelligent investor or unintelligent speculator? Hopefully, you answered with the former. However, the original intelligent investor—Benjamin Graham—may disagree with your self-reflection. You may actually be unknowingly speculating with your money—or worse, gambling with your money and close to losing it all.
As investors, we are often overconfident in our ability to pick stocks. That is why most of us would consider ourselves investors and not speculators. Graham turned this belief on its head, identifying and explaining three forms of unintelligent speculating that many so-called investors regularly engage in. Before it’s too late for you and your portfolio, let’s use his expertise to evaluate our own strategies and ensure we are not dangerously speculating with our money.
Are You Intelligent Investor or Speculator?
Throughout The Intelligent Investor, Graham provides readers with a few indications of unintelligent speculation. He first introduces the lesson in an early chapter with the following paragraph.
“There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.”
Have you ever gone to see the sequel of a movie in the theatres? You probably really enjoyed the first movie and believed the second would be the same. If this was the only criteria you based your decision on, you were speculating. Maybe you got lucky and it was an equally good movie. More likely, the sequel left you disappointed and wishing you hadn’t wasted the money.
The same pattern occurs all too often for many stock pickers. We are led to believe that a company is a strong investment simply because previous companies in the same field posted strong returns. When the company fails to achieve similar success, we realize with the luxury of hindsight that we engaged in pure speculation. That is why the first of Graham’s discouraged methods is speculating when you think you are investing.
The most common way we commit this wrongdoing is through the purchase of growth stocks.
“The term ‘growth stock’ is applied to one which has increased its per-share earnings in the past at well above the rate for common stocks generally and is expected to continue to do so in the future … Obviously stocks of this kind are attractive to buy and to own, provided the price paid is not excessive. The problem lies there, of since growth stocks have long sold at high prices in relation to current earnings and at much higher multiples of their average profits over the past period. This has introduced a speculative element of considerable weight in the growth-stock picture and has made successful operations in this field a far from simple matter.”
As humans, we are very attracted to growth stocks. Their successful past leads us to believe they make for solid investments. However, as intelligent investor, it is best if we avoid growth. Graham tells us that purchasing stocks with high multiples is actually speculative, and continued success is very difficult.
Some may argue that growth stocks are strong investments if purchased early, such as during an initial public offering. Graham would still suggest this purchase is unintelligent speculation.
“An elementary requirement for the intelligent investor is an ability to resist the blandishments of a salesman offering new common stock issues during bull markets… Of course the salesman will point to many such issues which have had good-sized market advances—including some that go up spectacularly the very day they are sold. But this is part of the speculative atmosphere … For every dollar you make in this way you will be lucky if you end up by losing only two.”
In December 1980, Apple had an initial public offering, selling shares for $22. A $990 investment at the time would now have grown to over $500,000. The only catch is that it was impossible to know Apple was going to become the first trillion dollar company. If you do consider this a plausible achievement, consider the IPO of VA Linux. The company had more projected potential and hype then Apple. On its first day of trading, it opened at $30 and closed at $239.25. Fast forward three years, and you’ll notice VA Linux stock selling for $1.19. There are only a few examples similar to Apple—but thousands similar to VA Linux.
Purchasing growth stocks and initial public offerings are only two examples of speculation being confused for investing. Recognizing when a purchase is speculative will save you money and disappointment. Next time you’re willing to pay to see the sequel in theatres, please at least consider the reviews first.
How Seriously Are You Speculating?
The second of Graham’s methods of unintelligent speculation is speculating seriously instead of as a pastime when you lack proper knowledge and skill for it. Have you ever tried to time the market? If you answered yes, then according to Graham, you are speculating too seriously.
“Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: by way of timing and by way of pricing … We are convinced that the intelligent investor can derive satisfactory results from pricing of either types. We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator’s financial results. This distinction may seem rather tenuous to the layman, and it is not commonly accepted on Wall Street. As a matter of business practice, or perhaps of thoroughgoing conviction, the stock brokers and the investment services seem wedded to the principle that both investors and speculators in common stocks should devote careful attention to market forecasts.”
It is important to recognize the inaccuracy of speculating. Predicting the market is nigh impossible, and so attempting to forecast the market is a waste of time. Unfortunately, Graham recognized that most people are wired to be speculators rather then investors.
“There is one aspect of the ‘timing’ philosophy which seems to have escaped everyone’s notice. Timing is of great psychological importance to the speculator because he wants to make his profit in a hurry. The idea of waiting a year before his stock moves up is repugnant to him. But a waiting period, as such, is of no consequence to the investor … What this means is that timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under his previous selling price.”
The majority of us would prefer to receive money sooner rather than later. This is an obvious fact. As Graham reminds us, intelligent investor should not be concerned with waiting to profit. Don’t take speculation too seriously—it is a hopeless approach.
How Much Can You Afford to Lose?
Lastly, Graham would strongly discourage risking more money in speculation than you can afford to lose. This rule is fairly easy to understand; however, many buyers find themselves in trouble when they disobey.
Graham and The Intelligent Investor are well-known for the promotion of the margin of safety. The concept provides for safety—or room for error—when speculating.
“We suggest that the margin-of-safety concept may be used to advantage as the touchstone to distinguish an investment operation form a speculative one. Probably most speculators believe they have the odds in their favor when they take their chances, and therefore they may lay claim to a safety margin in the proceedings … They rest on subjective judgement, unsupported by any body of favorable evidence or any conclusive line of reasoning … Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”
If you are ever hesitant about risking money, Graham provides clarity between investment and speculation. An investment is one that rests upon definite reasoning and evidence. Using your life savings to purchase the next promising cryptocurrency is speculation. With it being a relatively new area of investment, it would be nearly impossible to ensure a margin of safety. Even if your long-time friend has convinced you to speculate, be sure not to risk more money then you can afford to lose.
The Key to Smart and Safe Speculation
Benjamin Graham provided us with three methods of unintelligent speculating—speculating when you think you are investing, speculating seriously instead of as a pastime, and risking more money in speculation than you can afford to lose.
Even after the discouragement, Graham recognizes that speculating can be a lot of fun. He provides us with some insight on how to speculate safely.
“Speculation is always fascinating, and it can be a lot of fun while you are ahead of the game. If you want to try your luck at it, put aside a portion—the smaller the better—of your capital in a separate fund for this purpose. Never add more money to this account just because the market has gone up and profits are rolling in. Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.”
At The Broken Leg, we follow Ben Graham’s key lessons very closely. That is why we would consider ourselves intelligent investor and not unintelligent speculator.
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