Friday, May 31, 2019

Difference between investors and speculators...

Short URL for this post: http://bit.ly/Investor_Speculator

In his book 'Margin of Safety', the legendary investor Seth Klarman explains the difference between investors and speculators. To investors stocks represent a fractional ownership of business. They transact securities that offer an attractive risk reward ratio. Investors believe that over the long run security prices tend to reflect fundamentals of the business. Investors in a stock expect to profit in at least one of the three possible ways. From free cash flow generated by the business which will be reflected in higher share price or will be distributed as dividends, from increase in multiples and by the narrowing the difference between price and value.

Speculators on the other hand, buy and sell securities based on the expected price action based on the behaviour of others. For them securities are a piece of paper. Speculators are obsessed with guessing the direction of stock prices. They use technical analysis to predict the direction of market. Many investment professional are speculators in the garb of investors. Investors have a chance to make money over the long-term, while speculators are likely to lose it over time.

The author tells the story of 'trading sardines' versus 'eating sardines' to explain speculation. It was observed that sardines were disappearing from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, "You don't understand. These are not eating sardines, they are trading sardines."

Like sardine traders, many financial-market participants are attracted to speculation, never bothering to taste the sardines they are trading. Speculation offers the prospect of instant gratification. Moreover, speculation involves going along with the crowd, not against it. There is comfort in consensus.

Viewing stocks as piece of paper precludes rigorous fundamental analysis. Neither rigorous analysis nor knowledge of underlying business is required. Speculators play the 'greater fools game'. Speculative activity can erupt in Wall Street at any time and is not identified as such till considerable money has been lost.

Even assets can be catagorized as investments or speculations. Both can be purchased from market and both fluctuate in price. The main difference is that investments throw cash flow, but speculations do not. For example, stock is an investment, gold and other collectibles are speculation. Value of speculations fluctuate solely based on supply and demand since they do not throw any cash flow.

In financial market it is important to be an investor and not a speculator. Successful investor is unemotional taking advantage of the opportunity provided by the greed and fear of others. They respond market with calculated reason. Investors use the opportunities provided by Mr.Market, without looking up to him for investment guidance. It is important for investors to differentiate the stock price fluctuation from underlying business reality.

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