Today I wanted to discuss the differences among trading, speculating, and investing.
Investing, the topic to which this blog is dedicated, is the allocation of funds in such a way that the odds are on one’s side. In speculating, the odds are slightly or greatly against your side. In trading, the odds are significantly against you. So, for the gamblers out there, trading would be like placing large bets on single numbers in roulette – you can make some real money very quickly if your numbers pan out, but if you play for any significant amount of time you will lose a lot of money, and the longer you play the more likely you are to lose. Speculating is like playing on red and black or maybe on a third of the board at a time. You have a better chance of winning, but the odds are still against you and over time you will lose more than you win. Investing is like buying the casino, where now all of the odds are in your favor and you will, given time, win more that you lose. While the gambler may make a few quick wins and may sometimes walk away with more than she came with, the casino owner will always win if she keeps playing (which is why they gladly give out free rooms to “winners”).
In the stock market, trading involves doing things like buying a stock and then selling the same day if it goes up 1/4 point. Speculating involves buying stocks and then selling within a few months or putting extremely large bets (more than you’d be willing to lose) in a few stocks. The Enron folks who had their entire retirement funds in Enron stock were speculating. Investing is buying stocks and holding them for a long period of time – long enough to be able to predict with reasonable accuracy that the total return will be positive.
As with the casino, time is on the side of the investor. One may buy a stock that has great prospects and that should do well, but current events (like the Toyota acceleration issues) may drive the stock down temporarily. A speculator would then sell at a loss (if he were a good speculator and knew to cut losses). An investor may see that the company, over the long-term, would still do well and hold on through the “crises.” Actually the good investor would probably buy more at the lower prices if she still believed in the company’s long-term prospects.
In addition, stocks at some times trade at very high prices even when earnings are dismal and drop 10-20% even when things aren’t too bad, either because the whole market is going that direction or various traders and speculators are moving the price around. A good investor will not let the price fluctuations of the stock control his decisions on the quality of a stock. If one goes to the grocery store and good coffee is selling at $1 per pound, one would load up. Likewise, if it were selling for $100 per pound an investor wouldn’t buy some, thinking it would sell for $200 per pound later (although he might sell some that he already has). The price the market is willing to pay at any given time is just that. If it is very low, it may be time to buy more. If it is very high, it may be time to sell. Eventually it will come back to a “fair price”. The investor finds stocks whose fair prices he expects to rise over the long-term and buys them when the market prices are relatively low. If market prices get ridiculously high, he may sell some. Otherwise he holds on.