Does the stock market seem like Vegas to you? Suspect, possibly rigged? Congratulations, you’re normal.
Being cynical about “great money-making opportunities” is a good survival skill. You won’t win the lottery. Those too-good-to-be-true late-night TV offers are, indeed, to good to be true. That guy on the corner flipping cards is running a scam. Best to keep your hands in your pockets and firmly on your wallet.
Yet thousands of highly trained professionals on Wall Street take part in the stock market every business day. Famous universities stacked with PhDs run billion-dollar funds. Something reasonable, perhaps even predictable, must be happening here, right?
The answer is yes, but to really grasp the idea, you have to separate in your mind the difference between speculating and investing.
Imagine you have two college pals. One is straight-laced, Mr. (or Ms.) Button-Down-and-Get-Serious. Never up for a Friday night out. Monday classes are just 48 hours away!
The other is Mr. (or Ms.) Go-Hard-or-Get-Out. Invariably late, brings loads of cool, amazing strangers to the party, always shutting down the bar. A real people magnet, in both good and bad ways.
Each has a plan to open a small business, and each wants you to invest as a partner. The conventional friend has a plan that seems likely to plod its way to eventual profits but might kill you from boredom along the way. On the plus side, it’s his or her third business launch, each one a modest success.
Your crazy friend’s plan is really exciting, a truly ground-breaking idea. But the pal running it has started and failed at nine previous businesses. Every one of them was exciting. All of them were abject failures.
The first friend is an investment. The second is pure speculation.
Applying that to stocks is no different. Consider the words of Benjamin Graham, the mentor of none other than billionaire Warren Buffett and co-author of the seminal work Security Analysis:
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Let’s break that down a bit. There’s a lot of wisdom in these simple sentences.
“An investment operation is…”
Notice the use of the word “operation.” Graham sees investments as having a beginning, a middle, and an end. Exiting the investment is as important a concept as entering into it. Every investor who puts money into a business plan does so with a clear idea of how he or she will get that money back out, hopefully at a profit.
“…one which, upon thorough analysis…”
Analysis is the central idea here. If you don’t understand how the company makes money and how you will earn appreciation, dividend income, or both, you don’t understand the investment.
“…promises safety of principal…”
Buffett loves to talk about “margin of safety,” that is, buying a company so cheaply that the chance it will fall below that price is extremely low. In Graham’s argument, you are balancing the comparative safety of a bond, usually a U.S. government bond, against the chance a company will go bankrupt or otherwise drastically lose market value.
“…and an adequate return…”
What’s adequate? Well, if you know that a U.S. Treasury bond will pay you 3% in an environment of 2% inflation, you know that the so-called “risk-free” rate of return is 1%. A stock that provides you with a large margin of safety and a return of 3% or better beats the bond. That return might be in the form of appreciation, dividend income, or a mix of both, known as “total” return.
As Graham concludes, anything short on these requirements is simply speculative. Some warning signs to watch for:
1) You have no clear exit. The investment is thinly traded or exotic. Are you certain that there are more suckers, er, buyers out there for your great new investment idea?
2) The company doesn’t make money. This seems obvious, but the tech stock boom proved the inherent insanity in buying companies on the idea that they might make money soon.
3) The price is historically high. It might go higher, but there’s simply no margin of safety. Typically, a single stock that is making headlines solely because of its stock price (you know which ones) are headed for trouble. Wait for your chance to buy cheaper. You won’t regret it. If it doesn’t come, buy something else.
Here’s another Graham gem, oft-quoted in discussions of investment vs. speculation: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”
These words are magic. Speculators love the idea of voting with their dollars, right here, right now. It’s exciting, addictive even. Investors, however, weigh their decisions with an eye toward the eventual truth of the asset’s true viability.
And in time, the truth shall always be told.