Investing vs. Speculation - The “Spectrum Mindset”
On Friday, we discussed the investment-speculation spectrum and used the analogy of day turning to night, where the sunset represents the transitional phase between the two. Our intention was to present a mental map that helps distinguish between investment and speculation.
Recognizing the value of such examples, we have decided to provide another one today, this time utilizing the concept of vehicle traffic. The example we will focus on is the phenomenon of tailgating. Please note that we are not referring to the pre-game festivities associated with the upcoming NFL season (we understand your excitement in this regard).
Instead, we are referring to tailgating as the act of driving extremely close to the car in front of you. To better illustrate this scenario, imagine yourself on a freeway, tailgating the car in front of you. If you have ever engaged in this behavior (as the author of this piece reluctantly admits to), you are likely familiar with the potential consequences (please refrain from attempting this at home or on the road).
Maintaining a close distance while tailgating can seemingly be sustained as long as both your vehicle and the car ahead are traveling at the same speed. However, the situation drastically changes if the car in front of you suddenly hits the brakes.
A safe separation distance is a safety margin or empty road between you and the vehicle in front. Think about what happens as a pedestrian, when you are walking close behind someone on the street, and they stop suddenly, for some reason or other. What happens? You bump into them or take a sideways swerve to avoid bumping into them. However, if there was more than just a couple of feet between you and this person, you would notice him stopping in good time to avoid him safely. This is how it works on the road, too.
If we follow too closely to the vehicle in front, we leave no time and no space for things to change rapidly. Leaving you having to do an emergency stop or dangerous avoidance maneuver, in order not to hit the back of his car. And even this is not guaranteed. Too close means trouble waiting to happen.
We completely understand if this information is an obvious “DUH” moment and you start rolling your eyes. None of this should come as a revelation, especially if you possess a driver's license. This is basic knowledge that you learn in driver’s education.
Our point is as follows: The application of the same concept in investing was once considered fundamental knowledge in the realm of finance. Howard Marks, co-founder of Oaktree Capital Management and a contributor to the book, Security Analysis (6th Edition - p. 127), made the following observation to support the notion:
Today people attach the word “investment” to anything purchased for the purpose of financial gain—as opposed to something bought for use or consumption. People invest today in not just stocks and bonds but also in jewelry, vacation-home timeshares, collectibles, and art. But 75 years ago, investing meant the purchase of financial assets that by their intrinsic nature satisfied the requirements of conservatism, prudence, and, above all, safety. (emphasis added)
Ben Graham, of course, made the same point in The Intelligent Investor:
It seems a truism to say that the old-time common-stock investor was not much interested in capital gains. He bought almost entirely for safety and income, and let the speculator concern himself with price appreciation. (emphasis added)
We present you with a question: What has changed? Graham continues:
Today we are likely to say that the more experienced and shrewd the investor, the less attention he pays to dividend returns, and the more heavily his interest centers on long-term appreciation.
Graham uttered those words in 1949! So the “speculative mindset” was already taking over the “spectrum mindset.”
Often, it is said, the best approach to attaining something is not to actively pursue it. Benjamin Graham acknowledges this paradox within the realm of finance:
Yet one might argue, perversely, that precisely because the old-time investor did not concentrate on future appreciation he was virtually guaranteeing himself that he would have it, at least in the field of industrial stocks. And, conversely, today’s investor is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected he may in fact be faced with a serious temporary and perhaps even permanent loss.
Has the situation improved since then? We highly doubt it. Warren Buffett echoed the same sentiment 51 years later. Here is an excerpt from the 1990 Berkshire Hathaway investor letter, where he addressed “the dagger thesis” that pertained to low-quality, high-interest rate debt:
In the final chapter of The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Forty-two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses as the 1990s began.
Now, over 30 years later, the question arises: where do we stand? Unfortunately, we find ourselves facing a continued erosion that has spanned over a hundred years. This erosion can be attributed, to a significant extent, to complex and deeply ingrained incentive structures that are difficult to rectify. The consequences of these circumstances result in:
We are all tailgating in the realm of finance.
The notion that investing revolves around the concept of buying safety has faded away. Nowadays, the general perception is that investing is primarily focused on generating profits. The emphasis is placed on performance rather than the underlying process. We recently shared the following statement on our Twitter account:
Certainly, Warren Buffett addressed this in his 1990 investment letter, specifically in relation to junk bonds, delivering a blow of his own:
Wall Street cared little for such distinctions. As usual, the Street's enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce. Mountains of junk bonds were sold by those who didn't care to those who didn't think - and there was no shortage of either.
Therefore, if you are embarking on your trading journey today, you do have a choice to make. You can opt to follow the herd and engage in speculative activities, such as buying meme stocks, cryptocurrencies or whatever currently captures the most attention in the finance world. Alternatively, you can strive to grasp the wisdom imparted by Benjamin Graham and Warren Buffett and heed their advice. After all, their approach has proven more than successful over a span of many years.
