The Dangers of Speculation: A 10-Year Study 

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

Famous finfluencer Akshat Srivastava has now trained his guns at the wild speculation that's underway in the stock markets.

Taking a cue out of US chipmaker Nvidia's recent stock price crash, he has argued that no stock is safe days.

As per him, if a multi trillion-dollar firm like NVIDIA can fall by almost 20% in 2 days, one needs to understand that one is living in a highly speculative world.

Hmm....are we living in a more speculative world or a more volatile world?

I believe that investors and speculators always existed and at times, it was the investors who had the upper hand and on other occasions, the speculators.

To be fair to Akshat though, the average holding period for stocks has certainly gone down, at least in the US.

As per a study, while the average holding period stood at 7 years in the 1950s and came down to 2 years in the 1980s, it currently stands at an abysmal 5.5 months.

Yes, that's correct.

An average investor is in and out of stock in less than half the time it takes for the earth to take one full round of the sun.

Thus, Akshat seems to be justified in arguing that investors who hold on to stocks for such a short time may not be termed as investors in the real sense of the term.

They have moved to the category of speculators and are barely interested in the fundamentals of the underlying stock but only in making quick returns.

Well, Akshat does not stop here.

He has gone on to argue that everyone around us is gambling.

The only difference is that those who are gambling with knowledge are beating inflation and earning positive real returns, while the ones who are gambling without knowledge are putting themselves at serious risks of losing all their money.

Hmm...Akshat seems to be implying that investing in stocks still counts as gambling even if you are applying knowledge.

Well, if this is indeed what he meant then it is a dangerous statement to make in my view.

The very term gambling triggers an imagery of either winning big or losing big.

It implies that the underlying activity is all about luck and there's hardly any skill involved.

Is that really the case though? Is stock picking nothing but gambling at the end of the day?

To be honest, I don't like the term gambling and the attempts to differentiate smart vs dumb stock picking as knowledgeable gambling vs non-knowledgeable gambling like Akshat does.

To me, I'd prefer investment vs speculation. If done rightly, a stock can not only prove to be a safe investment, but it can also provide you with adequate returns.

However, if approached incorrectly, it can quickly degenerate into gambling and can cause a lot of wealth destruction.

Say you have a corpus of Rs 1 bn or Rs 100 crores and you are invited by two friends to buy their businesses in their entirety.

The first friend's business is currently loss making and has a debt that is well in excess of equity. However, he has promised a quick turnaround in the near future and is offering the business to you at a throwaway price.

The second friend's business on the other hand, is consistently profit making, has almost zero debt and is available at a PE of around 12x-15x. Besides, it also promises a steady, stable growth in profits if not a robust one.

Well, it does not take a rocket scientist to figure out that a sensible investor would indeed prefer the second business over the first one. The second business is profit making, is of good quality and is also available at an attractive valuation.

The first business, on the other hand, has lots of challenges and there's a big question mark whether it will even turn around given it has not done so far. Thus, there is a real risk of this business making no money even if available at a throwaway price.

However, this is not how investors behave in the stock market. A lot of investors are attracted to the first kind of business as some fancy stories are spun around them to lure the investors in. They are even made available at exorbitant valuations, thus leading to a double whammy.

Hence, you are indulging in speculation if you constantly buy these kinds of businesses.

True investors on the other hand prefer the second kind of businesses. These businesses are profit-making, have low leverage, boasts of strong fundamentals and above all, are available at attractive valuations.

If you are attracted to the first kind of business often, then it is a dangerous territory in my view.

It is speculation as you are speculating that the business will have a strong turnaround. However, turnarounds seldom turn, and your money is better off being invested in a sound business bought at decent valuations than a bad quality business, even if it is available at throwaway prices.

In fact, here's an interesting slide that was part of a presentation I gave about a year ago.

I created two different portfolios of 20 stocks each and tracked them over a 10-year period between December 2013 and December 2023.

The first portfolio was a portfolio of investment worthy stocks that were both fundamentally strong and available at attractive valuations. The second portfolio comprised of speculative stocks only.

In fact, here are the rules I followed. Investment worthy stocks were profitable in each of the last five years, had strong balance sheets, had a decent revenue size and daily average liquidity and last but not the least, had attractive valuations of being available at a discount to book value.

Speculative portfolio on the other hand, had companies that were loss making in each of the last five years, had debt to equity that was either negative or more than 1 and revenue and liquidity the same as the first portfolio.

The idea was to hold these two portfolios of 20 stocks each, for one year and then create a fresh portfolio with same rules for another year and so on. This went on for 10 years starting from December 2013 and ending in December 2023.

Well, here's the entire performance in front of you.

As you can see, the investment worthy portfolio not only managed to do much better than the speculative portfolio, it also outperformed both the BSE Sensex as well as the BSE Small cap index. It turned Rs 100 into more than Rs 1,300, a return of 13x.

Speculative portfolio on the other hand, underperformed the benchmark indices and could turn Rs 100 only into Rs 300.

Hence, it is clear that it pays to invest in investment worthy stocks as opposed to speculative stocks.

Thus, rather than thinking of investing as gambling, you'd be much better off segregating stock picking into investment and speculation and staying away from stocks that are speculative in nature.

These are stocks that have consistently made losses in the past, have debt that is well in excess of equity and could also be very expensive.

So, don't worry. Stock picking is not gambling at all. It can be turned into a low risk and safe exercise if you follow time tested principles of investment and avoid speculation as much as possible.

I hope I was able to drive across my point in this short presentation. Do let me know if you have any doubts by posting them in the comments section. I will take your leave for now and see you again in the next session.

Good bye and happy investing.