Investing vs. Speculation - The “Spectrum” Mindset
Last Friday, we left you with what we believe is a very powerful image and asked you to reflect upon it. If you haven’t had a chance to ponder its meaning, please go back and spend some time with it! In any event, here is how we feel about this, in Q&A format:
Question 1 - Can I invest in assets that don’t generate cash flows?
No, you can’t, ever. There is a reason why there is a “v” in the previous image we shared with you last Friday, it stands for value. Assets cannot be valued unless they generate cash flows. Further, if an asset cannot be valued, one cannot invest in it.
Question 2 - I don’t think I have heard this before. What do you mean?
We know this goes against much of what you have read, seen or heard, but please understand that the world of finance has similarities to how earthquakes happen.
Question 3 - Can you please elaborate on that?
From the U.S. Geological Survey, which was created by an act of Congress in 1879:
An earthquake is caused by a sudden slip on a fault. The tectonic plates are always slowly moving, but they get stuck at their edges due to friction. When the stress on the edge overcomes the friction, there is an earthquake that releases energy in waves that travel through the earth's crust and cause the shaking that we feel.
As we mentioned before, the concept that investing was only a sliver of trading activity was well-understood 100 years ago. Then the “tectonic plates” in finance started to move, in large part due to complicated incentive structures. First, everything in the stock market became investing and the “cheapness” element went out the window. Then assets that don’t generate cash flows became investing; it started with gold, and then continued with art, collectibles and of course, most recently, cryptocurrencies. “Apple trees” went out the window.
Question 4 - Yes, cryptocurrencies! I want to invest in them. Where can I read more about them?
Well, you can’t invest in them, that’s the whole point. If you want to dive into our position on this, take a look at our June archives.
Question 5 - Ok, will do. Let’s go back to stocks. Can you help me understand why when I buy a stock, I’m not necessarily investing? Everybody talks about people investing in the stock market.
Not everybody. Warren Buffett, for example, doesn’t. He (and Charlie Munger) have amazing insights on this, but if you need validation, remember that Buffett happens to be the fifth richest person in the world and we would be wise to understand his methods and philosophies. So, tell us, would you prefer to listen to somebody who mocks Buffett for being old and not going toe-to-toe with him on the merits, or would you rather listen to Buffett himself, who made his fortune through actual investing?
Achieving Buffett-level wealth is obviously no picnic in the park, but reaching a level of wealth that will give you a comfortable life is absolutely possible and that doesn’t happen overnight, it requires you having to put in the hard work.
Question 6 - What is that?
Here are your main options:
i) Learn how to truly value stocks, so you can compare price to value and buy only when the price is cheap enough; or
ii) Find people who practice Warren Buffets methods; those who are true investors going through valuation exercises similar to what we described above (and not following speculators who are chasing the price action); or
iii) If you continue to believe in America, buy a cheap index fund and ride on the coattails of great American businesses.
Question 7 - But that’s a lot of work.
You know what else is a lot of work? Going through retirement with not enough money. Having to work when you don’t even feel like it anymore. Your kids are being accepted into college, getting married, etc., and need your help, but you being unable to provide for them.
Question 8 - Hmm. What is achievable?
Between 1965-2022, a 57-year span, the S&P index returned 9.9%. Through a low-cost index fund, this kind of gross return would have been within reach. Over the same period, Buffett generated exactly double what the S&P index had returned, a whopping 19.8%
It is not lost on us that the legendary Ben Graham, over a 20-year period, achieved ≈20%, with the market returning 12.2%. Obviously, past performance is not an indicator of future results, but it does give you a sense of what is possible. 8-10% over the stock market every year may not seem much to you, but over a few decades, it actually makes all the difference. Think about it this way: If you put aside $100,000 today, don’t contribute anything else, and let that money compound annually at a 10% rate, in 30 years, you would have $1.74 million (You can use this calculator). Not too shabby, eh? Except at 20%, you would have $23.7 million. So, if you have $100,000 today, and achieve 10% a year, you’ll have a fantastic nest egg built for your retirement, but you’d still probably need to think about where to retire. If you earn 20%, the world becomes your playground.
Here is another way to look at it. If you can achieve 20% returns and the $1.74 million nest egg is enough for you, you don’t need $100,000 today. You don’t even need $10,000. In fact, even just $7,500 would turn out handsomely.
That sounds pretty unbelievable, doesn’t it? Invest $7,500 (we mean that, it has to be an investment and not speculation), never contribute another cent to your investment portfolio, and if you can somehow achieve the 20% return, you will still end up with a great nest egg in 30 years (here’s that calculator again to play with).
It won’t be easy and it is not for everyone. However, if you are willing to do the hard work and can get there, the result will certainly be satisfying.
Question 9 - This sounds too good to be true. Why are people not investing then?
You have to ask them, but one theory comes to mind. They want to make it really big, they want to drive a Lambo like their neighbor and they want it tomorrow. True investing can make you rich, but it won’t be quick. If you want that Lambo soon and your neighbor already has one (perhaps they purchased Bitcoin), you have to swing hard, speculate on the price action and assume all the added risk that comes along with that stock, altcoin, or whatever else you may be interpreting as an “investment.”
Hey, it might work out, as it has for a few; we are not saying that it never works. What we are saying is that i) that’s not investing; and ii) statistically, it is more likely than not that it won’t work for you.
Question 10 - Do you have any proof for that?
Sure we do, we don’t like to assume things, let's take a look at Terrence Odean, a finance professor at UC Berkeley who believes trading is hazardous to your wealth. He looked at this from a variety of angles and the results were obvious. People become overconfident in their abilities, trade too often and end up doing even worse than the indexes themselves. Here is the Journal of Finance (PDF) paper that he co-wrote with Brad Barber.
Question 11 - Ok, I need to think about that. What is that orange speculative investment zone in your picture? Is that like cryptocurrencies or something?
No, crypto does not exist in this picture because it is not an investment; there are no cash flows. If there is a crypto that generates cash flows, then it may be an investment, at the right price, but a majority don’t. The orange zone consists of trades of stocks (or other cash flow generating assets) where the price is nearing your value estimate, but they still are not cheap enough to qualify as an investment. They exist in that middle zone between investing and speculation, hence the phrase “Speculative Investing.” It’s akin to the sunset, so to speak, when day transitions to night.
Question 12 - Many use that term (speculative investing) for crypto, art, etc.
Many are also wrong. Remember, the tectonic plates are shifting all the time and crypto is just the latest shift; A financial earthquake may be forthcoming.
Question 13 - Ok, so if it is cheap enough, I’m investing, if it is too expensive, I’m speculating, and if it is neither too cheap nor too expensive, I am engaging in speculative investing,
Exactly. That’s the “spectrum” mindset we have been discussing over the last few days.
Question 14 - How cheap is cheap enough?
It depends on your risk tolerance, but here are two data points that can be helpful to you. The first is an excerpt from Benjamin Graham on Value Investing by Janet Lowe:
Realize that you are unlikely to hit the precise “intrinsic value” of a stock or stock market right on the mark. A margin of safety provides peace of mind. “Use an old Graham and Dodd guideline that you can’t be that precise about a simple value,” suggested Professor Roger Murray. “Give yourself a band of 20 percent above or below, and say, that is the range of fair value.’”
The second comes from a Ben Graham speech (PDF) that he gave somewhat later in his life:
Also, I should require that the buy-decisions based on this approach involve a margin-of-safety factor. This might well be a purchase price not over two-thirds of the central appraised value.
In other words, estimate the value of the asset and give yourself another 20-35% margin of safety. Do this with every trade you make and be honest with yourself. You will likely come out ahead over the long term and your future self will thank you.
