A Follow-On Article Expanded Upon Some of Grahamís Concepts. This Was Also Written in February 2009:
For Investors: Definition of Investment vs Speculation, Classification of Investors
As noted in the prior introductory essay on the topic, the author will be attempting to summarize the views of Benjamin Graham (1894-1976) on investing, as presented in two influential books, "Security Analysis" and "The Intelligent Investor". (Note that fellow professor David Dodd was co-author of "Security Analysis".) Later on in the series we will expand our horizons to consider the thinking of more recent notables as presented in newer works. But the works of Graham provide the basic foundation for understanding the topic. After you grasp his principles, it much easier to understand and benefit from later works.
First, we must define investment, as opposed to speculation. Graham defined an investment operation as "one which, upon thorough analysis, promises the safety of principal and a satisfactory return". Further, an investment operation is "one that can be justified on both qualitative and quantitative grounds". By definition, all other operations are speculative. These definitions can be better understood by means of examples: In the case of securities, purchase of investment-grade rated bonds or thoroughly-researched stocks meeting Grahamís rigorous criteria, intended as a long-term holding either to maturity (bonds) or permanently, with the return provided by interest (bonds) or dividends (stocks), with no use of margin or other borrowed funds, would be an investment. Purchase of stocks for a "quick turn", without conviction as to the long-term viability, or distressed bonds, or use of margin or other borrowed funds, would be speculation. Also speculative would be any trading in options, futures, forex, or even real estate where the rental income one could realize would not cover the costs of purchase or maintenance. By this definition, most securities transactions today are probably speculative. Media headlines, "investors dump stocks after bad news", and similar notations to Graham represented a gross misuse of the word "investor". It should read "speculators dump stocksÖ." instead. Graham said that speculation is not necessarily bad. For example, start-up capital for a new issue (IPO-Initial Public Offering) could only be done if speculators were willing to buy. Graham divides speculation into two categories: intelligent speculation, defined as "taking a risk that appears justified after carefully weighing the pros and cons", and unintelligent speculation, "taking a risk without adequate study of the situation". Buying a distressed bond of a bankrupt or nearly-so company for, say, 20 cents on the dollar, when analysis has revealed that the liquidation value will be 50 cents or more, would be an example of "intelligent" speculation. Watching CNBC and hearing a "talking head" say how company XYZ is a "hot stock" right now, and rushing to your computer to quickly buy at the market would be an "unintelligent" speculation. A huge industry has arisen in recent years, concurrent with the growth of the internet, to advise and support stock, futures, options, and currency trading, usually based on using "technical analysis" to forecast short-term movements.
This type of trading can be based on prediction of movements up or down (long or short, in market-speak), and can be done successfully for a time by practitioners employing a rule-based system with tight risk-management. A true "trader", who goes "flat" (ie, sells everything) at the end of each trading day would avoid the huge losses experienced by investors adversely affected by extreme market movements, at least over the short term. Properly approached, this could be a form of "intelligent" speculation. The key phrase here is "properly approached". It is estimated that only about 5% of the people doing this actually have a comprehensive, risk-controlled approach. The high turnover of these practitioners is evidence of this. Anyway, back to Graham Ė he acknowledged that speculation can be successful over short time-periods, but it is so difficult and fraught with peril that the prospect of long-term success is highly unlikely for most people.
The essence of investing versus speculation is investment relies upon analysis to determine the probability of a securities purchase, at a stated price, delivering the expected return while guarding against loss of principal, while speculation relies upon luck to a large extent. Success depends much more upon a nimble stop-loss and/or profit-taking strategy. The odds for long-term success are high with an investing approach, and are low with a speculative approach.
Graham classified intelligent investors into two classes, "defensive" and "enterprising". In both cases the investorís portfolio should be divided roughly 50%-50% between stocks and bonds, going as low as 25%-75% when stocks appear to be highly-valued and inflation prospects are low, and the reverse when good stock values are available or inflation is a concern. The difference is the defensive investor realizes he (or she) does not have the time or the desire to research stocks, and instead will utilize funds (either mutual funds, both open-end and closed-end, or the new exchange traded funds, or ETFs) as the vehicle for his/her holdings, both stocks and bonds, while the enterprising investor, who has the desire and willingness to put in the time to try to do better, will select his/her own securities. Today the availability of funds of all types would be mind-boggling to Graham, and in fact to anyone. It has never been easier to be a defensive investor. The key here is to go with broad-based index funds, and avoid high-fee managed funds or narrowly-targeted sector funds. Likewise, it is also much easier than in Grahamís day to be an enterprising investor. The information available online today online is massive. Companies file with the SEC (and make available to investors) financial data quarterly and annually, plus also notify the SEC (and also make available to the public) of any "material" developments affecting them. Also, stock purchases or sales by "insiders" (management and board members) or acquisitions of positions in excess of defined levels by large investors (such as Warren Buffet) are reported to the SEC. In Grahamís early days, few companies produced quarterly statements, and even annually only gave out minimal information. Much of Grahamís findings came from painstaking research of required company filings to pre-SEC government agencies, such as utility regulators. (Note that the SEC did not exist before 1935, being created in the Depression as part of the "New Deal".)
The next essay will outline Grahamís approach to selecting stocks as investments. Probably the most useful information to be imparted for most will be the realization of just how much work meaningful stock selection requires, and the difficult odds of beating the returns of the defensive investor, fully-invested in index funds, who prefers to play golf, fish, or whatever else there is to do besides researching stocks.