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Home , Benjamin Graham, Investor, Joseph de la Vega, Speculation, The Intelligent Investor

Commentary

Robert G. Hagstrom, CFA What is the Difference Between Chief Investment Officer Senior Portfolio Manager Investing and ? February 18, 2021

Reddit, WallStreetBets, Robinhood, selling and short squeezes, cryptocurrency, and special purpose acquisition (SPAC) have all lit up recent financial headlines. Rock stars and rappers are tweeting their best ideas to millions of traders. If you are going to win, “you have to be willing to lose it all” (1) has become the call for the “messiahs of .” (2) One might be correct to think the has lost its mind. However, this is not the finale but a recurring play on speculation that has periodically invaded markets since the first shares of were traded on the Amsterdam in 1602. And what unites these many speculative episodes throughout history has not so much been the reckless behavior of , but how the hyperactivity of wanting to make the most in the shortest period of time can suck the oxygen out of the stock market for -term investing. As mentioned, the tug-of-war between investing and speculation is nothing new. However, the persistent confusion over the difference is a mental mistake—some would say a chronic disease—that, too often, can become fatal for many investors. , the dean of analysis, rightly warned that the greatest danger investors face is not so much speculation, but acquiring speculative habits without realizing they have done so. And in doing such, investors can end up with a speculator’s return by believing that they were investing. That individuals have not learned the difference between investing and speculation is arguably one of the most important unlearned lessons that still haunts investors. And the fact that there is still confusion is cause for concern—particularly during the current financial times. For this reason, we believe it is important to share with you the following commentary, “What is the Difference Between Investing and Speculation?” written in February 2013 for the CFA Institute’s Enterprising . This commentary, written eight years ago, speaks to the ongoing challenge of distinguishing the differences between investing and speculation. As evidence, Enterprising Investor re-published the commentary this month, showing that now more than ever, it is critically important for investors to understand what is investing and what is speculation.

CFA Institute Enterprising Investor February 2013 What is the Difference Between Investing and Speculation? By Robert G. Hagstrom, CFA

What is the difference between investing and In his famous dialogues, de la Vega observed speculation? At first, the answer seems simple three classes of people. The princes of — (1) Otani, Akane. “Teens because the distinction is obvious — that is, until called “financial lords,”—were the wealthy and Their you actually try to answer the question. investors. The merchants—occasional Savings on GameStop speculators— were the second class. The last Stock: Their Parents are Go ahead. Take a few seconds and think about it. class was called the “persistent speculators” or Worried.” The Write down “investing.” Now write the definition. the “gamblers.” Journal. February 16, Do the same for “speculation.” If you are like me, 2021. frustration quickly builds because the answers do Since the Dutch shipping firm Vereenigde Oost-Indische became the first to trade (2) Zweig, Jason. “How not come quickly or easily, and they should. After its shares on the Amsterdam Stock Exchange, the Stock Market Works all, these terms have been a part of the financial Now: Elon Musk Tweets, investors and speculators have coexisted in the lexicon since Joseph de la Vega wrote Confusion Millions Buy.” The Wall marketplace. Over that 400-year time period, the Street Journal. February of Confusions in 1688—the oldest book ever noteworthy have offered their own definitions of 12, 2021. written on the stock exchange business. investing and speculation, but none have stuck. Investment Commentary

Philip Carret, who wrote The Art of Speculation the 20th century, was also a skilled buyer and (1930), believed “motive” was the test to seller of , bonds, , and determine the difference between investment . In addition to thinking about and speculation. “The man who bought United , he was intrigued with the stock States Steel at $60 in 1915 in anticipation of market. Tucked inside his magnum opus, The selling at a is a speculator…On the other General Theory of Employment, Interest, and hand, the gentleman who bought American Money (1936), is a chapter titled “The State of Telephone at $95 in 1921 to enjoy the Long Term Expectation.” Here, Keynes got right return of better than 8% is an investor.” Carret to the point, deciding to “appropriate the term connected the investor to the economics of the speculation for the activity of forecasting the business and the speculator to price. psychology of the market, and the term “Speculation,” wrote Carret, “may be defined as enterprise (a word he used for investment) for the the purchase or sale of securities or commodities activity of forecasting the prospective of in expectation of profiting by fluctuations in their assets over their whole life.” But the breadth of prices.” the chapter has less to do with the difficulty of Benjamin Graham, along with , defining investment and speculation and more to attempted a precise definition of investing and do with the observation that the lines between speculation in their seminal work Security the two approaches had blurred. It is the same Analysis (1934). “An investment operation is one point that is driven home 75 years later in The which, upon thorough analysis, promises safety Clash of the Cultures: Investment vs. Speculation of principal and a satisfactory return. Operations (2012). In his book, John Bogle argued that in the not meeting these requirements are speculative.” minds of most individuals, investment and Despite being the “dean of ,” speculation are now indistinguishable. Graham’s definition left readers wanting more — All market activity lies on a time continuum. a fact he confessed years later when he wrote The Moving from left to right, we observe buy and sell Intelligent Investor (1949). “While we have clung decisions in the stock market that occur in tenaciously to this definition,” said Graham, “it is microseconds, minutes, hours, days, weeks, worthwhile noting the radical changes that have months, years, and decades. Although it is occurred in the use of the term ‘investor’ during unclear exactly where the demarcation line is this period.” located, it is generally agreed that activity Graham was concerned that the term “investor” occurring on the left side of the time continuum is was being applied ubiquitously to anyone and more likely to be speculation, whereas activity everyone who participated in the stock market. residing on the right side is thought to be He explained: “The newspaper employed the investing. In Bogle’s opinion, investment means word ‘investor’ in these instances because, in the long-term ownership whereas speculation is easy language of Wall Street, everyone who buys more short-term trading. Carret concurred, or sells a security has become an investor, writing: “The time requisite for the regardless of what he buys, or for what purpose, accomplishment of the adjustment of prices to or at what price, or whether for or on values is a factor of great weight to the .” Graham went on to say: “Since there is speculator. Here he parts company with the no single definition of investment in general investor, to whom it is of little concern.” acceptance, authorities have the right to define it Thinking long term or short term might be a pretty much as they please. Many of them deny sensible starting point that helps us distinguish that there is any useful or dependable difference between investing and speculation. But a between the concepts of investment and of “stopwatch” definition leaves us woefully short of speculation. We think this skepticism is what is ultimately needed to better understand unnecessary and harmful. It is injurious because it the differences between these two approaches. lends encouragement to the innate leaning of A time element is simply not sufficient. The many people toward the excitement and hazards distinction between investment and speculation of stock market speculation.” is more complex than this. , best known as one of the Let me be clear. This not a sneaky attempt to founders of modern macroeconomics and demonize speculation and declare that only thought to be the most influential economist of investing is sacrosanct. Academic research clearly

2 What is the Difference Between Investing and Speculation? February 2021 Investment Commentary

demonstrates that the market benefits the unavoidable.” But Graham was quick to participation of both investors and speculators. distinguish between “good” and “bad” Although some investment purists might vote for speculation. “There is intelligent speculation as opening the stock market just one day each year there is intelligent investing. But there are many and on that day all buyers and sellers would ways in which speculation may be unintelligent,” transact business, the lack of daily liquidity would wrote Graham. likely do more harm than good for the But how can we distinguish between what is markets. Furthermore, despite its negative “good speculation” and “bad speculation,” or connotation, it can be argued that some types of “good investment” and “bad investment” for speculation are, in fact, socially redeeming. Lynn that matter, when we don’t even have a firm Stout, Distinguished Professor of Corporate and grasp of the basic definitions? Lacking clearly Business Law at Cornell Law School, in understood boundaries, individuals are “Uncertainty, Dangerous Optimism, and wandering aimlessly back and forth between the Speculation: An Inquiry into Some Limits of worlds of investing and speculation. And herein Democratic Governance” argued that a lies the danger. The stock market is now speculator that provides and liquidity dominated by a newly evolved species, the for the -averse farmer who wishes to enter into investulator—defined as an investor who a to sell his wheat at today’s unwittingly acquires speculative habits without price deliverable next month “fits the standard realizing it. Although more study is needed, it is of mutually beneficial exchange highly possible being an investulator is the reason that improves the welfare of both trading why so many individuals perform badly in the parties.” stock market. In addition to risk hedging and liquidity dealing, There is a very important passage in Graham’s told us that speculators who . Graham wrote: “The practice what is today called “information theory distinction between investment and speculation ” should be thought of as talented in common stocks has always been a useful one researchers who work aggressively to close the and its disappearance is a cause for concern. We price- gap. Carret shared the same opinion. have often said that Wall Street as an institution He wrote: “The speculator is looking for hidden would be well advised to reinstate this distinction weak spots in the market,” and as such, acts as and to emphasize it in all its dealings with the “the advance agent of the investor, seeking public. Otherwise the stock exchanges may always to bring market prices into line with someday be blamed for heavy speculative losses, investment values.” which those who suffered them had not been Even Graham in The Intelligent Investor came to properly warned against.” True today as it was 70 accept the necessity of speculation. “Outright years ago. speculation is neither immoral, nor (for most So, let’s begin. What is the definition of people) fattening to the pocketbook. More than investing? What is the definition of speculation? that, some speculation is necessary and

Robert G. Hagstrom, CFA, joined EquityCompass as a Senior Portfolio Manager in April 2014 and launched the Global Leaders Portfolio in July 2014. In 2019, Robert was named Chief Investment Officer of EquityCompass. Prior to joining EquityCompass, he was the Chief Investment Strategist of Legg Mason Investment Counsel, and before that, the Portfolio Manager of the Growth Strategy at Legg Mason Capital Management for 14 years. He has also served as President and Chief Investment Officer of Legg Mason Focus Capital and General Partner of Focus Capital Advisory. Robert is the author of nine investment books, including The New York Times Best Seller, The Way, The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy, and Investing: The Last Liberal Art. He earned his Bachelor and Masters of Arts degrees from Villanova University and is a member of the CFA Institute and the CFA of Philadelphia. www.equitycompass.com 3 Disclosures

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