Chapter 1: Investment vs Speculation
On chapter 1 of the Intelligent Investor, the author Benjamin Graham has focused on his readers to set forth the differentiation between Investment and speculations. There might still be confusion on the basics of investing, and this chapter lays the foundation for the rest of the book.
Benjamin Graham discusses the idea of value investing and stresses the significance of a methodical and disciplined approach to investing. Investing should be seen as a means of achieving long-term financial security rather than as a sort of speculation or gambling.
I also wrote an article on: Things You Need To Know About Investment And Speculation
What is an Investment
Investment is defined as a purchase made with an intention of creating income or capital growth. An asset’s value increasing over time is referred to as appreciation.
The author, Benjamin Graham in his book The Intelligent Investor defines investment as follows: An investment is an operation is one which, upon thorough analysis promises safety of principal and an adequate return.
As per the author, anything not meeting the above mentioned requirements are mere speculations.
What is Speculation
The act of engaging in a financial transaction that carries a large risk of value loss but also carries the hope of a sizable gain or other significant value is known as speculation. With speculation, the chance of a sizable gain or other form of compensation more than offsets the risk of loss.
Speculation noting but taking bets on a conditions based on mere intuitions or tips from peers. Speculations is gambling on an output without backing the bet with any research, analysis and risk mitigation.
The author used this chapter to differentiate a real investor from the rest of the crowd. The author wants to prevent its readers from using the term investor to anybody and everybody in the stock market.
During the Great Depression (1929 to 1932) many financial institutions had labelled stock market investing as a speculation business and only Bonds were considered as an investment.
Conditions When Speculation Becomes Un-Intelligent
Speculation is neither illegal nor immoral. As there is intelligent investment, there could be intelligent speculation. But the mistake arises when people treat their speculation as investment. Speculations are addictive and fun, especially for a full time trader who always sits in front of the computer charts.
Here are three conditions when speculation becomes unintelligent:
- Speculating when you think you are investing
- Speculating seriously instead of a pass time
- Risking more money in speculation than you can afford to lose
If you want to try your luck on speculation, put aside a portion of your money (the smaller the better) just for speculating in the market. It is advised to never add more money into this fund just because the markets are in your favour of your bets and the profits are rolling in. Also, never mingle your speculations and investment in your same account.
When investors tend to invest in a stock, considering its fundaments, there could still be instances when the market participants are speculating on the stock at the prices favourable to you.
An investor needs to not only stay away from speculation, but also identify these speculative behaviours in his own portfolio to avoid falling prey for the herd mentality. An investor needs to be financially and psychologically prepared for adverse effects.
Speculations are necessary, as it creates liquidity in the market. Due to the effect of speculations, the prices of the stock are either available at a discount or are traded at a premium. Thus, allowing the investor to enter and exit a stock in the long term.
Author believes that people who take bets on hot stocks by leveraging their positions are nothing but speculators.
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A portfolio of an investor is subject to the period of investment and his risk taking ability. Author believes that, ideally Bonds investment should not be less than 25% or more than 75%. An investor with a lower risk appetite can go for 75% investment in Bonds. And the rest of the investment in Equity.
- Bonds provide lower rates or return, but the returns are definite and does not severely get impact by the performance of the stock markets.
- Equity investment are higher in risk, but also yield higher returns when invested correctly.
Timing the Market for Portfolio Diversification
The Author, Benjamin Graham explains this topic with an example:
During 1965 the Bonds gave return of 3-4%, and during the same time the stocks provided an dividend income of about 3%, in line with the capital appreciation of the stock. It is evident that, during this era, investing in stock would be considered more preferable.
During the period of 1970s the interest rates started rising and so the interest yield on Bonds. The bonds started providing a return of 7-8% against the equity investments, that could be uncertain. Thus, this era was more preferable for investing in Bonds.
According to Graham, investing should be seen as a strategy for achieving long-term financial security rather than as a sort of gambling. In contrast to short-term market volatility, the author advises investors to approach the stock market with care, patience, and an eye towards long-term value.
Graham also emphasises the need to diversify one’s portfolio to reduce risk and the significance of undertaking in-depth study and analysis of potential investments.
He also advises against making investments in businesses purely based on their track record or current market conditions, emphasising the significance of paying close attention to a business’s foundations and financials.