1. Investment versus Speculation

This chapter outlines viewpoints that will be set forth in the remainder of the book - in particular, the concept of an "appropriate portfolio" for an individual, nonprofessional investor.

Investment versus Speculation

The reader is encouraged to reject the common perception that an "investor" is anyone who buys or sells securities. An investor applies a disciplined approach to buying securities, seeking to preserve capital and achieve sustainable long-term growth. A speculator is merely looking to short-term profit, and is characterized as a person who buys securities they don't understand, often motivated by emotion - that is, he has the attitude and behavior of a gambler.

Speculation is not illegal or immoral, and for most people it is not "fattening to the pocketbook." And the author has no problem with the practice of speculation - but it should be regarded as a pastime rather than a chief source of revenue, and one should never speculate with more money than he can afford to lose. Most importantly, an individual should recognize that he is speculating rather than investing.

Speculation is fascinating, and can be fun when you are "ahead of the game." If you want to try it, set aside a small portion of funds for this purpose. But always keep the two activities separated. Never mingle your speculative and investment operations in the same account, nor any part of your thinking.

Even for the investor whose approach is sober and whose focus is long, term, the purchase of any security involves a belief that the future value of a security will be higher than its present value - and this belief comes at some risk of being inaccurate. The difference is largely the perspective of the individual in question: if he purchases with disregard to value and desire for a short-term profit, his behavior is speculative.

Results to be Expected by the Defensive Investor

The defensive investor is an individual chiefly interested in preservation of wealth and who does not wish to be bothered with investing except as necessary to maintain the value of his holdings against erosion by inflation.

Such an investor was traditionally advised to split his investment in some proportion between high-grade bonds and stocks, chiefly favoring bonds for the certainty of the interest they will accrue, but having some proportion in stock to mitigate the risk that market inflation will exceed the return rate of the binds he has purchased.

At various periods in history, stocks have outperformed or been outperformed by bonds - but the principal of a bond is much better protected than the price of a stock. This certainty is of greater value to the defensive investor than the prospect of undertaking risk to maximize his return.

(EN: The author goes into some detail about specific periods in history in which a bonds significantly outperformed stocks, but ultimately, this is moot, as these trends cannot be predicted with accuracy over the course of a decade.)

In terms of stocks, the defensive investor is better served by purchasing shares of well-established investment funds with a conservative (market) investment strategy rather than attempting to mange his own stock portfolio.

It is also recommended that the defensive investor leverage "dollar cost averaging," which means investment in equal amounts at regular intervals (monthly or quarterly) to mitigate fluctuations in stock prices - whether the market happens to be high or low at any given point, his purchases will balance out to an average cost over time. Specifically, he is not seeking to time or predict the market by purchasing when the stock is "low."

Results to be Expected by the Aggressive Investor

The aggressive investor desires to attain better results than the defensive or passive strategy will provide. However, he stops short of speculation, in that he takes a long-term view of his return, and seeks to ensure his results will not be significantly worse than the market.

A few common strategies employed by those who seek to beat the market return are mentioned:

The author has already expressed a negative view about the potential for success using any of these tactics, and historically, the vast majority of investors who use such devices have not obtained a satisfactory long-term return, nor even the safety of their investment principal.

Any attempt to select stocks that will outperform the market suffer from two foibles: the accuracy of prediction and the behavior of others in the marketplace. While anyone can demonstrate the performance of stocks in the past with complete accuracy, no-one yet has shown the ability to consistently do so for their future performance.

Even when attempting to choose stocks for their long-term performance, the investors handicaps are basically the same. Experts go astray, and individual investors who lack the quantity and granularity of information are even less likely to predict long-term earnings.

However, it is reasonably logical to assume that an investor can have sustained results that outperform the market if his choices are based on firms that are inherently sound (such that they will outperform firms that are unsound) as well as those that are not fashionable on Wall Street (in which case, other investors consider predicted future returns in determining the price at which they will presently sell.)

Speculators are driven by motives that are similar to changing fashions - causing the price of stocks to fluctuate "too far" in both directions. The individual who moves ahead of the majority can buy lower and sell higher than those who forestall purchases and sales in hopes the price will move further in a given direction.

Also, a given stock may be undervalued due to lack of interest or "unjustified popular prejudice." Very often, speculators follow the motions of other speculators, rather than considering the intrinsic value of a given stock - such that an investor motivated by independent thinking can more accurately identify a prospective winner or loser before there is significant motion in the market. This principle is entirely sound, but its successful application is not an easy art to master.

Ultimately, these strategies are overbroad. Rothchilds' maxim of "buy cheap and sell dear" makes perfect sense, though he does not explain how one may accurately know when a given stock is cheap and when it is dear. And while other investment strategies, including the famous "Dow Theory", are more mathematically complex, their basic principle and basic flaw is the same.

There are also a fairly broad array of "special situations" that historically have resulted in significant (20% or better) annual returns. These are unusual events, such as a merger or acquisition, the collapse of a firm, or the aggressive entry of a new supplier to a market. Such deals are highly profitable for those who are aware of them prior to the majority of the market - though most "outsiders" who attempt to latch on to such events often act too late, when the price of the security has been affected by the expectations of speculators who get the information before them.

Another example of a "golden opportunity" is the initial public offering (IPO) of a stock, in which the initial issue of a security is done at a price that is significantly less than it will trade in the market once it is available to a wider array of investors. However, the difference between issue price and market price works in both directions, and there are ample examples of IPOs that tanked rather than skyrocketed - though fewer speculators are inclined to brag as broadly about their failures.

Even so, the enterprising investor still has various possibilities that provide a reasonable chance of achieving better than average results (perhaps a 5% premium) at a level of risk that is not quite so extreme. The author will (later) describe approaches for stock selection for the aggressive investor.