Seth Klarman Quote On Investing Versus Speculation

Seth Klarman Quote On Investing Versus Speculation

by VW StaffFebruary 12, 2014, 9:58 pm

Investing Versus Speculation From Seth Klarman’s Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor

Mark Twain said that there are two times in a man’s life when he should not speculate: when he can’t afford it and when he can. Because this is so, understanding the difference between investment and speculation is the first step in achieving invest-ment success.

To investors stocks represent fractional ownership of under-lying businesses and bonds are loans to those businesses. Investors make buy and sell decisions on the basis of the cur-rent prices of securities compared with the perceived values of those securities. They transact when they think they know something that others don’t know, don’t care about, or prefer to ignore. They buy securities that appear to offer attractive return for the risk incurred and sell when the return no longer justifies the risk.

Investors believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses. Investors in a stock thus expect to profit in at least one of three possible ways: from free cash flow generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends; from an increase in the multiple that investors are willing to pay for the underly-ing business as reflected in a higher share price; or by a narrow-ing of the gap between share price and underlying business value.

Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others. They regard securities as pieces of paper to be swapped back and forth and are generally ignorant of or indif-ferent to investment fundamentals. They buy securities because they “act” well and sell when they don’t. Indeed, even if it were certain that the world would end tomorrow, it is likely that some speculators would continue to trade securities based on what they thought the market would do today.

Speculators are obsessed with predicting-guessing-the direction of stock prices. Every morning on cable television, every afternoon on the stock market report, every weekend inBarron’s, every week in dozens of market newsletters, andwhenever businesspeople get together, there is rampant conjec-ture on where the market is heading. Many speculators attempt to predict the market direction by using technical analysis-past stock price fluctuations-as a guide. Technical analysis is based on the presumption that past share price meanderings, rather than underlying business value, hold the key to future stockprices. In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.

Market participants do not wear badges that identify them as investors or speculators. It is sometimes difficult to tell the two apart without studying their behavior at length. Examining what they own is not a giveaway, for any security can be owned by investors, speculators, or both. Indeed, many “investment professionals” actually perform as speculators much of the time  because of the way they define their mission, pursuing short-term trading profits from predictions of market fluctuations rather than long-term investment profits based on business fun-damentals. As we shall see, investors have a reasonable chance of achieving long-term investment success; speculators, by con-trast, are likely to lose money over time.