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Investing framework: Investor or speculator?

Jun 9, 2008

In the previous article, we discussed the concept of ‘margin of safety’ and its application. In this article, we shall distinguish between an investor and a speculator.

  • Earlier articles in the series

    Investor or speculator: Definition
    An investor bases his decisions mainly by studying and predicting the underlying business (long term investing), corporate events (event based arbitrage), demand & supply scenario (commodities) etc. He ensures a margin of safety in his predictions and does not aim for false precision. He also does the spadework required- qualitative study of the company/competitors (long term investing), building a portfolio of independent bets (event based arbitrage) etc.

    On the other hand, a speculator bases his decisions mainly by studying and predicting the movements in prices. He does not ensure a margin of safety in his predictions.

    Investor or speculator: Why is the distinction necessary?
    It is important to distinguish between investment and speculative transactions because they involve different degrees of risk (defined as the possibility of loss) and time horizon. As Ben Graham mentioned in The Intelligent Investor, "Only rarely can one make dependable predictions about price changes, absolute or relative." Hence the expectations of an investor and a speculator should be different.

    Investor who sometimes speculates
    It is inherently difficult to resist speculation for three reasons. First, it is difficult for most people to resist the opportunity of making a quick buck. Second, we all harbor a secret belief in our ability to predict prices. Third, speculative positions are often not apparent at the first glance.

    The first two causes can be remedied by clearly identifying and separating investing and speculative positions in both one’s thinking and in the funds deployed. They should never be mixed together.

    For the third cause, let us take an example from the flavor of the season: Oil and Gas. The sector is divided into upstream (ONGC, Cairn etc), midstream (GAIL, (Gujarat Gas etc) and downstream (IOCL, BPCL, HPCL). RIL is present in upstream as well as downstream activity.

    The upstream segment involves three major drivers- movement in crude price (downside prediction is critical. comparatively easier), changes in the amount of recoverable reserves (upside prediction is critical. difficult) and share of downstream under recoveries (downside prediction is critical. moderately difficult). Hence, buying the stocks of upstream companies when prices are low enough to provide the margin of safety can be classified as investment. Buying these stocks at full prices must be viewed as speculation.

    The midstream segment involves two major drivers- movement in transmission tariffs (downside prediction is critical. comparatively easier) and changes in volumes (upside prediction is critical. comparatively easier). Hence buying the stocks of midstream companies at low or even reasonable prices can be called investing as the business conditions provide the margin of safety.

    The downstream segment involves three major drivers- movement in crude price (downside prediction is critical. difficult), changes in product prices/ the amount of under recovery (upside prediction is critical. difficult) and product volumes (comparatively easier. higher volume hurts the sector!). A speculator might look at the recent price history of the share prices of these companies and notice significant decline of late. But given the quicksand like nature of the underlying business, low price alone will not provide the required margin of safety for investments. Hence, any positions taken in the downstream segment is likely to be labeled as speculation.

    We shall continue with our discussion on building an investing framework in the next article.

    Reading is an excellent way to develop one’s investment framework. We urge you to refer to investment classics (books, articles and speeches) in the original.

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