All market activity lies on a time continuum. Moving from left to right, we observe buy–sell decisions in the stock market that occur in microseconds, minutes, hours, days, weeks, months, years, and decades. Although it is unclear exactly where the demarcation line is located, it is generally agreed that activity occurring on the left side of the time continuum is more likely to be speculation, whereas activity residing on the right side is thought to be investing. In Bogle’s opinion, investment means long-term ownership whereas speculation is more short-term trading. Carret concurred, writing: “The time requisite for the accomplishment of the adjustment of prices to values is a factor of great weight to the speculator. Here he parts company with the investor, to whom it is of little concern.”
Thinking long term or short term might be a sensible starting point that helps us distinguish between investing and speculation. But a “stopwatch” definition leaves us woefully short of what is ultimately needed to better understand the differences between these two approaches. A time element is simply not sufficient. The distinction between investment and speculation is more complex than this.
Let me be clear: This not a sneaky attempt to demonize speculation and declare that only investing is sacrosanct. Academic research clearly demonstrates that the market benefits from, and is optimized by, the participation of both investors and speculators. Although some investment purists might vote for opening the stock market just one day each year and on that day all buyers and sellers would transact business, the lack of daily liquidity would likely do more harm than good for the capital markets. Furthermore, despite its negative connotation, it can be argued that some types of speculation are, in fact, socially redeeming. Lynn Stout, Distinguished Professor of Corporate and Business Law at Cornell Law School, in “Uncertainty, Dangerous Optimism, and Speculation: An Inquiry into Some Limits of Democratic Governance” argued that a speculator that provides insurance and liquidity for the risk-averse farmer who wishes to enter into a forward contract to sell his wheat at today’s price deliverable next month “fits the standard economic model of mutually beneficial exchange that improves the welfare of both trading parties.”
In addition to risk hedging and liquidity dealing, Milton Friedman told us that speculators who practice what is today called “information theory arbitrage” should be thought of as talented researchers who work aggressively to close the price–value gap. Carret shared the same opinion. He wrote: “The speculator is looking for hidden weak spots in the market,” and as such, acts as “the advance agent of the investor, seeking always to bring market prices into line with investment values.”
Even Graham in The Intelligent Investor came to accept the necessity of speculation. “Outright speculation is neither immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable.” But Graham was quick to distinguish between “good” and “bad” speculation. “There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent,” wrote Graham.
But how can we distinguish between what is “good speculation” and “bad speculation,” or “good investment” and “bad investment” for that matter, when we don’t even have a firm grasp of the basic definitions? Lacking clearly understood boundaries, individuals are wandering aimlessly back and forth between the worlds of investing and speculation. And herein lies the danger. The stock market is now dominated by a newly evolved species, the investulator — defined as an investor who unwittingly acquires speculative habits without realizing it. Although more study is needed, it is highly possible being an investulator is the reason why so many individuals perform badly in the stock market.
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