What is the difference between investment and speculation? Unfortunately many people tend to confuse the terms and even use the two interchangeably. In this post I'd like to put forward my views on what the difference is and how it applies to the Australian Stock Market.
In his book, Security Analysis, Benjamin Graham discusses the difference between investing and speculating at length. Graham describes the difference between the two succinctly using the following words:
"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."
I think this sums it up nicely. If you approach each stock market investment with Graham's words in mind, you cannot help but do well over the long term.
The concern I have with speculation is that there is not normally any fundamental basis for entering a particular investment. A stock is bought because there is an expectation that the price will rise (normally over the short term) and it can then be sold at a profit. The problem lies in the fact that the expectation of a rise in price is based on observations of whether the price is rising or falling, or on what the price has done in the past. It seems to be solely about identifying patterns in price and volume.
The issue I have with this approach is that price does not necessarily reflect the value in the company. Over the course of weeks or even days a company's share price can fluctuate wildly without any news from the company in question. Is it possible that the fundamentals of the company have changed so dramatically over such a short period of time? In most cases it's unlikely. Sure - there are cases where a major change in the company's fortunes becomes known to the stock market leading to a change in valuation of the company's shares. But in most cases it's just investor sentiment driving prices.
So the next time you consider the purchase of a company's shares you should bear Graham's words in mind. Do you understand the company well enough to be confident of it's fortunes into the future? Is there sufficient value present to justify the price being asked? If you can't answer yes to both of these questions, should you really be investing? Remember that you can afford to pick and choose. The Australian stock market continues the throw up opportunities for patient investors.