Investing versus speculating

Global shares began the year on fire with stock markets ‘melting up’! In the first four weeks of the year the global index gained almost 5% with the UK stock market gaining nearly 9%, Shanghai 7% and the US 6%. All in less than a month. Then over the space of two weeks the UK lost 7%, Shanghai 12%, the US 8% and all of those gains were gone. Investor over confidence had washed away and was replaced with indecision. These wild gyrations of the market in this short period of time provides us with a good opportunity to consider the difference between investing and speculating.

Using stocks as an example, what do we look for in a stock?

We look for growth in the share price and distribution of income which combined give us a return on our investment. The longer this continues the more our wealth will grow.

There are over 3,000 listed stocks and 3,500 managed funds available in Australia. With such a vast universe of options to pick from how do we select what is more likely to give us the return we want consistently?

This is where the two approaches to stock selection – investing versus speculating – can bring vastly different results over the longer term.

Investing involves implementing a strategy that will provide for growth and income over an extended period. Three qualities that indicate a stock is more likely to achieve continued growth in price and payment of dividends, regardless of the asset class or the industry, are:

• A strong competitive advantage – examples include the company’s size and the cost advantages associated with their size, commercialisation of intellectual property or being in a monopoly or duopoly position e.g. CSL
• Recurring, predictable earnings – provides for income over a 3 – 5 year period which then enables planning for capital expenditure, debt reduction or market growth
• Capable management –with a history of managing costs, promoting credibility and honesty and consistency in decision making which promotes stability.

Analysing these attributes to evaluate the company against competitors in the market can enable a smart investor to accurately predict how income and future market value will be generated.

This methodical approach reduces the risk in the investment, provides an exit point by indicating when a stock is over- or under-performing, and can give confidence to retain the stock over the longer term. This is what investing is all about.

The alternate approach is to speculate. Speculating is the search for short term gains or ‘out performance’ and accepting the increased risk that comes with it. Characteristics of speculating include:

• Relying less on academic tools and measurements while following market trends, the 24 hour news cycle, jumping on that ‘sure thing’ mentioned at a Sunday BBQ or buying a stock that worked before because its price ‘has to go up’
• Stock price movements outweigh business fundamentals in stock selection
• The risks of buying high or selling low are overlooked for short term price movements.

Risk is increased as the short-term effects of external factors is heightened. Think of inflation figures released overnight in a foreign market, or currency movements following an off the cuff comment by a foreign president – both of which can result in a sharp decrease in a stock’s value from one day to the next.

The old adage that which grows slowly endures – that which grows quickly withers and dies can haunt the investor who buys into a ‘popular’ asset looking for a quick gain.

So while both investing and speculating have a place in the market, speculating is a high risk method that doesn’t guarantee you will achieve your long term wealth creation goals. Investing, while not as ‘sexy’ as speculation (when it comes off), provides a methodical approach to put you on the path to achieving your goals of providing for a better future. Your Future of Choice.

So while the market volatility that we are experiencing is a good reminder about the risks that come with speculating, the virtues of investing hold true through calm and volatile times.