The 1973 book by Benjamin Graham, The Intelligent Investor, is, probably, the only investing book that is needed to get to the root of the issue at hand. I consider it to hold the "first principles" of investing and have been lugging around the same dog-eared version since college. Like all good books, Graham begins with a definition of the topic at hand.
Investment versus Speculation
Graham begins in Chapter 1 with a definition of investing from his textbook Security Analysis, written in 1934. There, investment is defined as "An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." [Emphasis mine].
Between 1934 (when Security Analysis was published) and 1973 (when The Intelligent Investor was published), all common stocks were regarded by the general public as speculative issues - which makes sense when you consider that there was a depression from 1929-1932.
Around 1973, Graham writes, the situation flipped. Every participant in the stock market was considered an "investor", which is similarly demonstrated by today's headlines, such as a recent Wall Street Journal article titled "Investors Take Sink-or-Swim Approach to Struggling Crypto Startups" or "Retail Investors Keep Buying The Dip". Consider Graham's definition of investment above, and compare it to an inexperienced member of the public putting their hard-earned cash into this week's Bitcoin startup or buying stocks in companies just because the price is lower - without regard for how that price corresponds to the underlying value.
As Graham writes, "...[t]he newspaper employed the word "investor" in these instances because, in the easy language of Wall Street, everyone who buys or sells a security has become an investor, regardless of what he buys, or for what purpose, or at what price, or whether for cash or on margin." It's amazing that nearly 50 years after that sentence was published, the practice remains the same.
To illustrate the point, see the video below where George and Jerry believe that they are investing in a stock, but what they're really doing is speculating that the stock will go up in price (not value!):
Graham writes that while the distinction between investment and speculation is useful, Wall Street ought to do a better job reinstating the distinction so that the general public does not blame those institutions for heavy speculative losses sure to result to those who have not been properly warned about the distinction between the two practices. While I respect Graham's well-meaning point here, decades of experience observing the market and its participants tells me that when tides are rising, the public will take credit for their investing prowess, and when the market crashes, Wall Street is to blame, no matter how bold the print is on the disclaimers of risky products (the Street deserves some of the blame for shoddy business practices, for sure, but there is an element of individual responsibility that must be respected as well).
Lest this post read like a sermon on "true" investing, I do agree with Graham when he writes that "...[o]utright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone." Speculation is, in fact, necessary in our system of capitalism because as Graham pointed out, someone has to take the risk. For example, Graham's definition of investing includes a requirement that if you're considering investing in a company, it ought to have a historical record of at least five years of $X dollars, and, preferably, you can invest at less than $X.
However, companies such as Amazon, Microsoft or Google (or even earlier, think Edison Electric Light Co.) would never qualify as an investment under Graham's strict definition because they simply didn't have that historical record; every company starts somewhere. This also applies to smaller startups today. If you've "invested" in a startup (especially an early-stage, pre-revenue, "we're still figuring it out" type-startup) you're actually speculating because there is no historical evidence to give you safety of principal and an adequate return. Should that be a successful venture, you should therefore enjoy speculation-sized gains because your capital shouldered the risk.
This brings us to Graham's three ways to unintelligently speculate: 1. Speculating when you think you are investing; 2. Speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and 3. risking more money in speculation than you can afford to lose. I know several very successful entrepreneurs who speculate in early stage start-ups, but most all of them know that they're speculating, and they've earned enough capital from their own entrepreneurial pursuits to speculate with, say, 1% - 10% of their capital. And, again, our system of capitalism needs this speculation to survive and to give bright people capital to pursue their ideas which, hopefully, end up benefitting society in some way. And, not to mention, when you're doing well in these speculative ventures, it can be fun!
As returns on speculation are not possible to calculate, in the next post we'll examine the returns that can be expected by the different types of investors identified by Graham - Defensive and Aggressive.
Zachary Oliva is the: