What is an “investment”? How do you define it? I think this is an important question to answer because many of those who consider themselves investors today are really just speculators, in my view. In fact, the markets may have never seen a smaller share of true investors than they do today.
To back this statement up I’ll use Ben Graham‘s definition of an investment: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” This makes perfect sense to me. If you can’t be assured that your principal is protected and that you will receive a reasonable rate of return then you are not investing; you’re simply betting on higher prices.
Now speculating in the markets is fine so long as you acknowledge the fact that you’re speculating. The best speculators are self-aware. They don’t pretend to be investors. They are great at riding trends and making money in all sorts of environments but the one thing they do best is take losses quickly. This prevents them from making really big and costly mistakes. And this is where a speculator who believes he is an investor is most at risk.
A speculator who believes himself to be an investor does not adopt the most important rule of speculating: take losses quickly. He believes, mistakenly, that because he is investing rather than speculating he needs not worry about making really big and costly mistakes.
A true investor who, through performing due diligence, is able to commit capital only to opportunities that allow for a margin of safety and in a reasonably diversified way can afford to take this approach. But one who avoids this sort of due diligence and also shuns the idea of taking losses quickly puts himself at risk of catastrophic losses.
And when you consider how much money today is allocated to strategies that purport to be “investing” yet shun the due diligence required it’s not hard to see how many people are potentially setting themselves up for the sort of losses both intelligent investors and successful speculators assiduously seek to avoid.
As the Financial Times recently reported, “Just one-tenth of the US equity market’s trading volumes now comes from fundamental stock investors.” Certainly, some percentage of the other 90% comes from self-aware speculators. But, with passive investing taking over the majority of funds last year, the share of speculators in the market that believe they are investing despite their lack of investment or speculative discipline is certainly greater than ever before.
What is most worrisome about this is that while these speculators who call themselves investors do not appreciate risk today, they inevitably will once it materializes. As they say, “There are no atheists in foxholes,” and there are no passive investors in a major bear market.
It’s one thing to trust your investment discipline when prices are crashing. A true investor has a strong idea of the fair value of assets in his portfolio regardless of what Mr. Market quotes them at in real time. But it’s something else entirely to watch prices crash and have no idea of or any methodology at all for determining fair value and thus assessing further risk after significant losses have already been incurred.
It’s only discipline and conviction, achieved by way of thorough analysis, that allow investors to take advantage of the rare opportunities presented by severe market stress. And the lack of conviction, produced by the lack of thorough analysis, is what turns speculators who believe themselves investors into panic sellers.
So it might be a good idea to level with yourself and honestly acknowledge whether you are truly an investor or a speculator. And if you find you are a speculator who believes himself an investor then you might want to implement some sort of loss mitigation strategy whether it be hedging, trend-following, or just a broader form of diversification. After all, you take out insurance against your home and your car; why not take out some form of insurance against your financial assets?