A trip to the US has me thinking about speculation. A host of famous investors implore us to distance ourselves from speculation and focus on investing. I am in complete agreement. And in the most extreme cases it is easy to separate speculators from investors. But there are shades of grey and the border between the two activities can be difficult to discern.

I spent a couple days with a mate in Boston. He is a successful and sensible man with a career in finance. During COVID he started buying NFTs. On my last trip to the US he was regaling me with how much his collection had increased in value. Things have since changed.

Is the type of company you buy a determining factor?

“The first task of the bargain hunter is to narrow the field and separate the solid prospects from the ones that are counting on hopes, prayers, and miracles.” – Peter Lynch

Most of us – including my friend – can agree that trading computer generated images is speculation. Things are a little more complicated when it comes to the share market. There are several dimensions to explore in the juxtaposition between speculation and investing.

The first is the actual investment. In the share market we are buying and selling companies. The act of investing in a business is not speculative at face value but there are speculative companies.

The Australian share market is a good example of this phenomenon. In a study published on Firstlinks, Ashley Owen estimated that 37,000 companies have been listed in Australia between the 1800s and 2018. Of that total, 27,750 – or 75% - have been mining companies that have been delisted. This generally results in a total loss for shareholders.

The very nature of mining lends itself to speculation. A company lists on an exchange to raise capital to finance the start of mining operations. In many cases the size of the find is difficult to fully estimate, the cost to set-up operations is substantial and the revenue outlook vague as commodity prices can swing wildly. It is no wonder that so many mining companies didn’t make it.

Yet it isn’t just miners that are speculative. Many newly listed companies have not yet become profitable. Investors in public or private start-ups are doing so in the hope that they become profitable before running out of money or sources of additional funding. A situation that ZIP (ASX:ZIP) shareholders are currently facing.

The chances of losing an entire investment in these speculative companies is far higher than one in a blue chip established company. Those larger companies are profitable, have more resources and a more diversified product line to survive the vicissitudes of the business cycle. Yet the profit potential is far different. That unprofitable start-up may become the next Microsoft (NAS: MSFT) which brings countless riches to early investors.

Does that mean that buying a speculative company makes someone a speculator? Not exactly.

The price paid often separates a speculator from an investor

“The line I draw in the sand is that if an asset has cash flow or the likelihood of cash flow in the near term and is not purely dependent on what a future buyer might pay, then it’s an investment. If an asset’s value is totally dependent on the amount a future buyer might pay, then its purchase is speculation.” – Seth Klarman

Can the same company be considered a speculation and an investment? The short answer is yes – just not at the same time. An investment in the share market involves risk. As investors we want to make sure we are compensated for that risk. How much we are compensated is reflected in the difference between the price and what we think the company is worth over the long-term.

Many speculators don’t bother to estimate the value of anything they buy. They are simply hoping that somebody will be willing to pay more in the future. They are willing to pay a price for a share that is so exorbitant that there is no realistic possibility that the future performance will live up to the expectations baked into the price.

An investor focuses on the value of company that is being purchased with the expectation that over the long-term the price will reflect the underlying value. In doing so the investor accounts for the risk inherent in an unknowable future for the company by ensuring there is an adequate margin of safety between the estimated value and the price.

Behaviour of investors

“It makes no sense for individual investors to jump in and out of the market. People who trade in that way rarely die rich, whereas the patient investor often does.” – Philip Carret

Another dividing line between speculators and investors is behavioural. Frequent trading and short holding periods are speculative in nature. A buy and hold approach is generally more aligned with investing. The distinction between the two approaches is captured by Buffett’s famous quote which states that over the short-term the market is a voting machine and over the long-term it is a weighing machine. He is referring to the differing drivers of share prices over shorter and longer time periods.

In the short-term there are multiple drivers of share prices. Investors respond to each new piece of data / news to guess the future. The future for short-term traders is measured in minutes and hours. It is very difficult to know exactly how the market will react to an event because the interpretation is often coloured by the general mood of the market. If the market is feeling euphoric then bad news will be ignored and good news will be emphasised. The opposite holds true in a downcast market.

To be a successful trader over the long-term is extremely difficult. This is not to say that some people can’t do it. But some people also manage to be successful gamblers while most of us are simply contributing to the profits of casinos.

Over the long-term the fundamentals of a company drive results. Simple as that. Once highly touted start-ups frequently go out of business. Investor expectations of the future simply didn’t materialise. If a start-up succeeds and grows into a household name it is likely that early investors do very well.

Over the short-term the fundamentals do little to influence the share price. Therefore, by definition not holding shares for the long-term means a lack of focus on the value of a company. A sign of speculation.

Can you invest and speculate?

“The investor must recognize that there are uncertain, and hence, speculative elements inherent in any policy he follows.” – Ben Graham

There is an important caveat to the story about my mate with the NFTs. The money he has spent – and lost – on NFTs is an insignificant part of his net worth. He has a large portfolio of traditional investments and owns multiple properties. The money he has lost on his NFTs will make no difference in his life or his ability to achieve his goals.

This is an important lesson about speculation. For people that are comfortably on track to achieve their goals there may be a place for to take some more speculative positions within a larger portfolio. A core satellite approach to investing encapsulates this notion where the majority of a portfolio is dedicated to solid blue-chip companies or index funds and a small portion is reserved for more speculative bets.

The speculative portion of a portfolio could be crypto, NFTs, frontier markets, unprofitable small caps or companies with a higher uncertainty of future outcomes. There are endless possibilities, but the key is to keep these bets small. Because they are bets. The pay-off may be huge but the chances of success are low.

The issue is that a lot of people don’t reserve speculation to a small part of their portfolio. And the sad irony is that many people who make outsized bets on speculative opportunities are the people that can least afford to do it. Countless times we’ve seen the most vulnerable members of society taking what little wealth they have amassed and putting it is very risky propositions. In many cases the people pushing these propositions are far better-off and profiting immensely.

Young people are another group of people that are prone to speculation. And as a society we encourage it. Afterall when you are young it is the time to take risks. Maybe in some parts of life but not investing. Young people are told they have plenty of time to make back any losses. Perhaps that is true. But in doing so they are giving up time in the market where an investment in a boring index fund can turn a small investment into a great deal of money.

We all dream of get rich quick schemes. Afterall waiting for rewards is no fun. The only problem is that taking the fast track to wealth rarely works. Focus on the business you are buying and the underlying value. Pay an appropriate price with an adequate margin of safety. Hold the investment for the long-term. Limit long-shot bets to a small portion of your portfolio. Those are the secrets to investing success