Investing or Speculation?

Happy Independence Day!

Financial-market participants, knowingly or unknowingly have become speculators. They may not even realize that they are playing a “greater-fool game,” buying over valued securities and expecting – hoping- to find someone, a greater fool, to buy from them at a still higher price. There is a great allure to treating stocks as pieces of paper that you trade. Viewing stocks this way requires neither rigorous analysis nor the knowledge of the underlying businesses. Moreover, trading in and of itself can be exciting and as long as the market is rising, lucrative. But essentially it is speculating, not investing.

Value investors pay attention to financial reality in making their investment decisions. Speculators have no such tether. Since many of today’s market participants are not investors, business fundamentals are not necessarily a limiting factor in securities pricing. The resulting propensity of the stock market to periodically become and remain overvalued is all the more reason for fundamental investors to be careful, avoiding over priced investments that will require selling to another, even greater fool.
Just as financial-market participants can be divided into two groups, investors and speculators, securities can often be characterized as either investments or speculations. The distinction is not clear to most people. Both investments and securities can be bought and sold. Both typically fluctuate in price and can thus appear to generate investment returns. But there is one critical difference: investments throw off cash flow for the benefit of the owners; speculations do not. The return to the owners of speculations depends exclusively on the vagaries of the resale market.

What was described so far really applies to Stocks and commodities.
Gold and Silver are speculations and so are the rare collections and paintings.
(courtesy: Margin of Safety, Seth A. Klarman.)
How does Options appear? Is it a speculation or an investment? It depends. In my opinion it is both. When the options strategy produces steady cash flow, it is by definition an asset; rather the option makes the underlying risk capital an asset.

Since options do have time expiration unlike stocks and can produce greater return on investment than stocks for the same amount of investment, the trading of options requires only technical analysis (MACD, Stochastic, Moving Averages of the underlying stock, ETF, Index) and virtually no fundamental analysis (return on equity, earnings growth rate, P/E ratio, etc. of the underlying Stock). It is indeed a short term speculation with a high probability of success. We are using the trend as our friend as the saying goes.

Another investment fundamental, if you will, is the velocity of money. Options due its nature of time bound expiration, better utilize the same money/asset over and over again. The stock investor, on the other hand is at the mercy of dividend yield and capital appreciation years on end while the capital is tied up which may look like eternity for some people.

Options are adjustable wrenches as opposed to a fixed wrench (stock)!

On a lighter note:

Why are they inventing new ways of losing money when the old ways are working just fine?
– Warren Buffett in an interview

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.