There is a very thin and blurred line between investing and speculating (or gambling). To have a clearer understanding of this, we would differentiate between the two.
There is a tendency for investors to be speculative when the markets are bullish and buoyant. However, for long term and profitable survival in the markets we must try and control this urge to speculate. After all, we are here to learn and apply investment management and not speculation management.
To be part of the speculative herd in a bull market situation has been the waterloo of many participants in the financial markets across the globe. This participant maybe an individual investor, a NBFC, a financial institution, a pension fund, a bank, or a brokerage. Some are responsible corporate citizens while others are not.
|Planning horizon||Relatively long, holding period of at least 1 year.||Very short, holding period a few days or weeks.|
|Risk disposition||Moderate, rarely high risk.||Normal to assume high risk.|
|Return expectation||Moderate returns at limited risk.||High return at high risk exposure.|
|Basis for decisions||Fundamental factors, careful evaluation of proposed investment.||Relies on hearsay, tips and market psychology.|
With regard to the differentiation between investors and speculators listed above it would be opportune to elaborate on these points of reference. We would first explain the investor's position and mindset; thereafter, we would explain the speculator's views in this regard.
Planning horizon: The investor would be willing to buy and hold stock positions for long periods of time and probably well beyond the 1 year listed above. This would mostly be the result of the investor having prepared himself both financial as well as psychologically for the inevitable changes in the prices of the stocks held in his stock portfolio. His intention would be to benefit from the advances in the value of his stocks at various levels of the market; in other words it is highly probable that most of his stock positions would turn out to be multi-baggers by the time he sells them. In a sense he would buy these stocks at prices which offer a fair discount over value to him; in other words he would be "buying low and selling high". Even if his intent were to indulge the short term on occasion, it would be with the full knowledge that he is now speculating.
The speculator on the other hand is seeking immediate gratification. Thus, he would trade within the day while buying some stocks and selling them later at the rise of a few points and selling other stocks and buying them back after a fall of a few points. Usually, the speculators would be in moment to moment contact with the trade desk of their broker. They are of the view that the life cycle of the earning capacity and capability of the selected stocks and their underlying enterprise can be replicated within the span of a trading day. This is also called day trading. The speculators may indulge margin trading and on occasion even the futures & options segment of the stock market to leverage their meagre financial resources.
Risk disposition: The investor would at all times seek a discount to the intrinsic value of the stocks he would buy subsequently for capital gains sometime in the future. For instance, he would seek stocks priced at levels at or below their book value per share; of course, the earnings per share would be at reasonable levels and maintainable into the future and the price earning multiplier would be at a lower level when compared with other similar stocks. Thus, the investor would need to wait while the stock price gains to levels at or above its book value per share and sell the stock at a reasonable profit. This price range may on occasion be the first point of profit; and depending on the future performance and outlook of the underlying enterprise the investor may find occasion to buy the stock again at higher price levels (including after a downward price correction from the recent higher price levels) and subsequently sell them at even higher levels. In this fashion and style the investor would be able to considerably reduce his risk exposure.
The speculator would be willing to take on a higher level of risk in expectation of a higher return in the short term. As his holding period is very short he is able to take on larger stock positions probably on margin. But given the short duration of his holding period he is unable to mitigate the risk in any fashion and style and the moment to moment stock price during the day (or a few days or weeks) would guide the decision to sell the stock at the gain of a few points during the day or a few percentage points during the week. On the flip side, if the stock price were to move against the speculator's position he would need to quickly sell it to minimize the loss. It would be the stock price which would rule the trading decisions.
Return expectation: The investor as already listed above would expect moderate returns from his stock market investments as he would be limiting his risk exposure to acceptable and reduced levels. However, the discerning investor with many years of experience would be able to compound his investment capital at a reasonable rate over the years of his investment time horizon. On average such compounding would be at 16% to 18% annualized and on occasion may be at levels of 50% and even more.
The speculator on the other hand would adopt a higher level of risk exposure in the expectation of a higher return in the short term. As such decisions are mostly based on the daily price volume data pertaining to the stocks selected for trading, they would not take into account the unsystemic risk associated with these stocks or the systemic risks associated with the stock market in general. If the speculator is right he has gains to be had, and if he is wrong he would have to book the loss and move on to the next trade. On most occasions it would be a zero sum game, as he would win some and also lose some.
Basis for decisions: The investor would consider the fundamental factors easily found in the balance sheet, profit & loss account and cash flow statements of the underlying enterprise. This study would revolve around the profit after tax which is also the earnings per share, dividends paid, and the present premium over earnings afforded by the current market price which is also called the price earnings multiplier. This study on most occasions would also expand into an understanding of the products and services of the enterprise, its plant locations, its markets and its relative position in such markets. To complete this study would require the investor to also gain knowledge of the management and an understanding of their management style. This evaluation of the stock would be in the lines of enabling part minority ownership in such enterprise for the investor.
The speculator would give little regard to an evaluation of the fundamentals underlying a stock. His trading decisions would be based mostly on tips, grapevine news and hearsay. It would indeed be market psychology at play as its the present price trend that is being addressed. His decision would be mostly based on the here and now with little or no regard to the future prospects of the underlying enterprise.It would surprise most to learn that in today's time and age the speculators usually call themselves short-term investors, probably in an attempt to bring recognition and dignity to their trade and craft. Indeed this would blur the distinction between investors and speculators even further; as the investors would now be the long-term investors while the speculators would be the short-term investors.