If you are somewhat interested in the stock market and you buy stocks from time to time, it would be extremely beneficial that you become familiar with the difference between investment and speculation. The difference is quite obvious, but it will require us to dig in a little deeper and define both terms. Benjamin Graham defined them like this: ” An investment operation is one which, upon thorough analysis promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
Price and Quality
Very straight forward, correct? To sum it up, everything that does not promise the safety of your initial investment and it does not offer you an average return- is a speculative investment. Therefore a sound investment practice will be mainly focused on the price and the quality of a chosen stock. With that in mind, an investment can not remain an investment regardless of its price- meaning if a stock was once a good investment at given price, it will not be regarded as investment at the much higher price, but as speculation. The majority of common stocks can be considered as speculative most of the time, simply because their price is too high to promise the safety of principal and an average return. (In order to understand more about stock pricing,you might want to read about Mr.Market)
QUANTITATIVE and QUALITATIVE
Additionally, Graham stated that ” An investment operation is one that can be justified on both quantitative and qualitative grounds“. Quantitative elements would be the very essential financial statements of the company. Things like the income statement, balance sheet, cash flow and many other statistical ratios.Overall quantitative elements you would be looking for in a company would be their capitalization, earnings, dividends, assets and liabilities. Qualitative elements of a company can be classified as their ‘soft’ or intangible qualities. Things like their geographical and physical characteristics, an economic moat (competitive advantage, brand name), the behavior of their management, the outlook for the industry, business etc. If you can justify the investment’s purchase price based on the mentioned criteria you are heading towards the right direction, otherwise you are entering into dangerously speculative waters.
One of the key differences between investment and speculation is that investment is solely based on the past, whereas speculation looks primarily towards the future. As far as investment is concerned, the future is something to be guarded against rather than to be profited from. This is simply because no one can predict the future and yet everyone tries to. To those investors who tried, the odds are not in their favor- just like we discussed on this page. Therefore if the future brings improvement, an investor will gladly profit from it. On the opposite side, an investor will be able to sleep at night knowing that no matter what the future brings his investment will at least return his principle back to him. However a speculator will most likely base his decisions from prospective developments that differ from past performance and therefore hope that the future will be bright. In the Part II of this series we will discuss some concrete examples of what investing vs speculating looks like.