Investment versus Speculation

Investment versus Speculation

August 26, 2023

In the film City Slickers, Billy Crystal takes on the role of Mitch, a radio advertising executive in his forties who finds himself in the midst of a typical mid-life crisis. Upon his wife's suggestion, he embarks on a two-week "vacation" cattle drive.  On the trail, Mitch reaches a pivotal moment where he discovers the secret of life from the trail boss, Curly (played by Jack Palance, who earned an Oscar for the role). Curly raises a single finger and proclaims that the secret of life boils down to "one thing." When questioned about the nature of this "one thing," Curly responds with a cryptic yet empowering statement: "That's for you to decide."

If there was “one thing” to producing long-term investment success, our cumulative 50-plus years in the industry would point to the distinction between investment and speculation.  Without it, you are unlikely to be a successful steward of wealth.  Without it, you might as well be like Mitch and his city slicker buddies, herding cattle without knowing how to ride a horse.    

Many consider investing to be simply buying any security or asset.  “I invest in stocks.”  “My money is in art.”  “I’m long crypto.”  “I invest in start-ups.”  They *may* be investing.  Or they may be speculating.

Investing legends such as Buffett, Munger, Bogle, and Keynes have made the distinction.  Synthesizing their work, here are Flatrock’s definitions:

  • An Investment is an asset where the expected primary return comes from future cash flows.
  • A Speculation is an asset where the expected primary return comes from increases in price.

Take the two most common financial assets – stocks and bonds.  When you purchase a company’s stock, you become an owner and expect to share in the future profits of the company.  Those are the future cash flows for a stockholder.  When you purchase a bond (from a government or a corporation), you become a lender and expect to be paid back with periodic interest payments and eventual repayment of principal, the future cash flow for the bond investor.  Real estate would be similar with cash flows from rent. 

Let’s contrast Investment with Speculation by revisiting John’s childhood when he collected baseball cards.  The purchaser of the card only gets a return if someone else comes along and is willing to pay a higher price.  There are no intervening cash flows.  Baseball cards don’t pay dividends or interest.  You’re betting on a rise in price, not cash flows. 

The value of the baseball card depends on the derisively coined (yet instructive) concept known as the "Greater Fool Theory".  A fool may pay $50,000 for a piece of cardboard with a picture of a baseball player on the front but a greater fool will come along and pay $100,000 for said cardboard.  Baseball cards aren’t alone.  Lots of assets derive the entirety of their return from someone paying a higher price.  Some have great historical returns (especially over the short-term.)   And you’ll no doubt hear about them from CNBC and other talking heads.

We outline a broad (by no means comprehensive) list of Investments and Speculations below.    

John Maynard Keynes, the famed economist, said it best: the speculator is occupied with the activity of forecasting the psychology of the market.[i]  After over fifty years working with some of the brightest minds on Wall Street, we can conclusively say that forecasting the psychology of the market is very, very hard.  (After taxes, it’s near impossible as we’ll cover in a future note.)  On the other end, Keynes said an investment involved evaluating the prospective yield of assets over their whole life.  Importantly, we can mostly observe the starting yield for most assets on the Investment side of the ledger such as stocks, bonds and real estate.  We can also infer the growth in yields based upon long horizon history. 

Just like Speculations, prices can change dramatically on Investments too over the short term.  Price change on stocks and even bonds often dominate day-to-day, month-to-month, and year-to-year returns.  Sometimes just as much as crypto or NFTs! 

But patience is key.  Over longer horizons, the twenty to thirty years that line up with our clients’ planning horizons, speculative swings in price typically even out.  The return on Investments almost entirely comes from stable or growing cash flows in the form of dividends, earnings, bond interest payments and rental income.  Those fundamental anchors, when allowed to compound for decades, we believe more reliably drive long horizon investment success. 

[i] Keynes, John Maynard (1936). The General Theory of Employment, Interest and Money. London: Macmillan (reprinted 2007)


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