Financial Topic Demystified
Investor or Speculator?
The recent market downturns across the world have many so called investors looking for advice on where they should be investing their money. We have had a couple of such requests from prospective clients. e.g. Should we take our money out of Australian shares and invested in cash? This is quite a natural request from what we would call speculators rather than investors. So what is the difference between these terms?
The following is taken from a chapter of our book entitled - It's Time You Knew The Truth.
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Many good investment books and investment authors go out of their way to point out that there is a distinction between an investor and a speculator. It is worth articulating this difference, so that you can be sure that if you want to be an investor, you are acting in the appropriate manner.
The risk of not acting like an investor is profound reduction in investment returns. A famous study by Dalbar Incorporated looked at how successful US investors in managed funds had been. The average return from the investment index over the period from 1985 to 2006 has been 11.90%. The actual managed fund investor over this period received an annual return of only 3.90%.
This points out simply, concisely and clearly the difference between a long term investor who was prepared to simply hold the market portfolio and earn 11.90% a year and a speculator who tried to time when they bought and sold into the market, and invested in active funds that were expensive to own and incurred trading costs. They received a return of only 3.90%.
The first mistake, trying to time when we buy into the market and when we sell is one that should be avoided. People tend to react counter-intuitively to market movements. When markets fall in price, such as the 25% - 35% decline that we saw in October 1987, people tend to be sellers of investments. When markets rise strongly in value, such as between 2003 and 2006, people then start to become more interested in buying investments. In reality, when markets decline sharply the expected long term return from the market actually increases. Conversely, when markets have already increased sharply in value the expected long term return actually decreases.
We have addressed six different dimensions of an investor as opposed to a speculator, and compared the activities of an investor with the activities of a speculator. Let's be very clear from the start, our view is that while there may be a few successful speculators, being an investor is the intelligent and successful approach for the vast majority of people. The dimensions are:
- Investment Time Frame/holding period
- Investment Benefit
- Expectations of Returns
- Awareness of Fundamentals
- Understanding the Business and Knowing the Management
- Reactions to Fluctuation in Price
1. Investment Time Frame/holding period
An investor looks to hold investments for the long term, periods of at least five years or more.
Speculators have a shorter horizon for holding an investment. This means that the portfolio of a speculator is characterised by higher levels of trading. This leads to greater transactions costs (brokerage for shares, agent's fee etc for real estate) and tax inefficiency.
2. Investment Benefit
An investor looks to an investment to provide a strong stream of 'earnings'. More than likely their expectations are that the stream of earnings will increase over time. For example, a share based investment will be used to provide an ever increasing stream of company earnings, which are paid out in the form of increasing dividends to the investor.
A speculator's focus is on selling the asset purchased with a price rise in mind. They are not concerned with the income produced from the asset, just that it goes up in price.
3. Expectations of Returns
An investor's aim is to receive a reasonable return on their investment over a period of time.
A speculator is often focused on receiving a very high return on their investment. Given the relationship between risk and return, this implies greater risk for the speculator.
4. Awareness of Fundamentals
An investor purchases an asset with an understanding of the underlying fundamentals of the investment - the earnings of the company, the dividends paid, or the rental stream from a property.
A speculator, who has purchased the asset because they believe it will go up in price, is not greatly concerned with the fundamentals of the investment. In fact, with the use of derivatives a speculator might even bet on the price of an investment going down.
5. Understanding the Business and Knowing the Management
The attitude of the investor who purchases shares is that they are becoming part owner of a business and therefore they must have some understanding of the business and the quality of the people managing that business.
The speculator is much less concerned with the nature of the business and who is managing it. The aim is to buy shares that will go up in price and provide a quick return, rather than the long term ownership of an outstanding business.
6. Reactions to Fluctuation in Price
An investor is less about the day to day fluctuations in the price of the asset they own. Because they are more interested in the long term earnings of the asset, price does not overly concern them. In fact, a drop in price may allow them the opportunity to increase their investment in the asset at a lower price.
The speculator is far more concerned with the price of the asset, as the primary aim is to own an asset that goes up in price.
It is probably worth considering that speculation and investment are not mutually exclusive and people will show characteristics of both. The most profound question, then, is who wins - speculators or investors? Chris Leithner, in his book 'The Intelligent Australian Investor' (Wrightbooks, 2005), concluded that 'Although there are undoubtedly some individual exceptions, speculators as a class are almost certain to lose money. Investors tend to make money because their operations conform to certain laws of economics and human actions.'
Examples of Speculation
Two activities that have the characteristics of speculation include the use of software to trade on the sharemarket and the use of deposit bonds to purchase property prior to construction with the intent to resell the property before it is completed.
Most share trading software is classic speculation. It looks to purchase shares, hold them for a short period while they go up in price, and then sell them at a profit. There is no interest in the underlying business, fundamentals, or management. It seems counter intuitive to me that someone who has found a way to trade and earn excellent returns would then sell that system to other people. What will happen is that, as more people buy at the same time as each other, the price of the stock will go up and, as they all try to sell at the same time, the price of the stock will go down. That will reduce the returns for everyone, including the person who initially developed the profitable trading system. In fact, if we ever find a profitable way to trade like this, the last thing we will be doing is sharing it with everyone else!
ASIC has spent some time warning people about software trading systems. A document on their consumer website, FIDO encourages consumers to:
Be realistic. No-one has ever found a foolproof system to make money on the stock market. No piece of computer software can make you get rich quickly - so don't believe inflated claims of success. Even the most experienced professional traders and investors make losses. Some of Australia's major investment managers, stockbrokers and institutions have millions of dollars worth of computer power to help them invest. They still make losing trades as well as profitable ones.
Warning
Beware of promoters of such software who:
1. promise high returns over a short period
2. do not disclose the potential losses and risks of actively trading shares or futures
3. claim the program will make you a successful trader
4. provide examples of large profits made by investors in the past as a result of using the program or
5. overseas promoters/vendors who promote trading software for sale.
An example of speculation in real estate involves the use of deposit bonds to purchase property 'off the plan', with the intent of reselling the property before settlement, at a profit. This fits the definition of speculation, the short term acquisition of an asset with the aim of an increase in price. When a buyer can be found to purchase the property at a profit it works well. If a buyer cannot be found it is a disaster.
An article entitled 'Flat Broke' by John Stensholt and Amanda Gome, published in the Business Review Weekly in July 2003, shows how badly this speculation can turn out. The example they give is of high-rise apartments in Darlinghurst. These apartments were purchased with deposit bonds of $10,000. The price of the apartments at the time of purchase was $1 million. At the time of the article being written the apartments were being advertised at $750,000. Effectively, and assuming that the apartments could even be sold for $750,000, investors (speculators) were looking at making a $250,000 loss before transaction costs, a negative 2,500% return on their initial investment of $10,000. The article also notes that 'the bonds are secured, usually against family homes, and if a buyer defaults at the time of settlement, the bond issuer will pay out the vendor and pursue the buyer.'
There seems to be much to advocate the approach of the investor over that of the speculator. Perhaps though, the greatest danger of all is to think that you are an investor when you really are a speculator. In that case you are engaged in much riskier behaviour without acknowledging it. We suspect the property speculators in the example would have told you that they were property investors.
Our suspicion is that the media promotes speculation over investment. Most of the media stories we are exposed to are of boom stocks that have gone up, the rise or fall of the sharemarket on a daily basis, and the list of suburbs where property prices are about to boom. It simply isn't a great story to talk about the way Wesfarmers shares have steadily increased their dividends over the past 15 years, or the way a well located property has delivered an ever increasing stream of rent to an owner.
Furthermore, the advertising section of the media must be able to generate higher response rates from share trading software or property development opportunities that promise speculative returns. After all, none of us get too excited by the advertisement that offers a reasonable return for an appropriate rate of risk and with low level of fees. Speculative advertisements seem so much more likely to satisfy our emotional need for great returns and more of everything!
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So how do we apply this for our clients?
We know that acting like an investor is important to a successful investment experience. Our focus is on building a portfolio with increasing investment earnings over time - not on trading to try to exploit short term movements in the price of assets.
We also accept the reality of volatility in a portfolio. That means that we will not panic when investment markets fall, rather we accept this as a reality of investing.
Most of all we don't pretend that we have skill in market timing, switching investments between asset classes to maximise investment returns.
Lastly, we know that much of the 'noise' generated around investment is really about speculative activities. As investors we give ourselves permission to focus on the key aspects of building successful investment portfolios, such as asset allocation, and ignore the noise and hype surrounding us.
