This is a special guest post by Robert R. Johnson, Ph.D., CFA, CAIA . He is a full professor of finance at the Heider College of Business at Creighton University and a director of RS Investment Management. He formerly served as the Deputy CEO of CFA Institute and was responsible for many facets of the organization – most notably, the venerable CFA Program.  He is co-author of a recently published Wiley book entitled Investment Banking for Dummies. He also recently co-authored a McGraw-Hill book titled Strategic Value Investing: Practical Techniques of Leading Value Investors. The book examines many different formulations of value and shows how leading value investors ply their trade.  Bob is also an editor of the Quarterly Journal of Finance and Accounting.

investing

Investing Versus Speculating

Most of us fancy ourselves as rational and prudent investors.  Unfortunately, when the rubber hits the road we become speculators in investors’ clothing.  The ongoing crisis in the Ukraine has brought this to the forefront.  How you responded to the news of the turmoil – and, more importantly, how you responded to the reaction of the financial markets to the turmoil – says a lot about whether you are truly an investor or speculator.

As my co-authors and I describe in the recently released book Strategic Value Investing, true investing involves:

  1. An analysis of the current state of the economy and its future trajectory;
  2. An evaluation of which industries are expected to do well in that economic environment; and
  3. An evaluation of the companies within the industry that are priced below their intrinsic value given the state of the economy, the industry, and the fundamental characteristics of the company (earnings, cash flows, assets, liabilities, and the like).

Too often, however, what is termed investing is merely speculation. The purchase of a security with the hope that a buyer will pay a higher price for it at a later date—perhaps because its price had been following a similar trajectory in the past—is speculation, not investing.  Many individuals weaned on CNBC and infotainment offerings such as Fast Money mistake speculating for investing.

How a true investor approaches world events was exemplified when Warren Buffett appeared in a live interview on March 3rd on CNBC’s “Squawk Box.”   When it seems that all of the talking heads were fixated on what this latest crisis implied short-term for the markets and how “investors” should adjust their portfolios in response, Buffett said, “When I got up this morning, I actually looked at a stock on the computer (for) the trades in London (of a stock) that we’re buying, and it’s down and I felt good. We were buying it on Friday, but it’s cheaper this morning and that’s good news.” Will he buy more? “Absolutely.” Mr. Buffett went on to say that would be true even if he knew Ukraine would turn into a major conflict.

In other words, other than Mr. Market providing him with an even more advantageous short-term buying opportunity, Buffett was not considering taking any long-term investment actions as a result of the political situation in the Ukraine.  The recent events didn’t cause Buffett to alter his long-term expectations of the underlying business and the economy at all.  Buffett didn’t believe that these events changed any of the three elements described above.  From an investment perspective, it didn’t make any difference to Buffett whether the markets rose or fell in response to the events in the Ukraine.

Now, be honest – how did you react?  Did you feel the need to pare your holdings when you heard Putin was sending troops into the Crimean peninsula?  Did gold or other commodities look more attractive to you as a result of the crisis in Eastern Europe?

Reaction to short-term events is what leads individuals to underperform the market averages.  It is well-documented that dollar-weighted fund returns are lower than time-weighted returns.  The reason is that people let their emotions get in the way.  This causes them to “buy high and sell low.”

The situation in the Ukraine is obviously a human crisis and I don’t want to minimize the human tragedy that is playing out.  A year ago to the day, I was in the Ukraine as a representative of the Muskie Fellow Program lecturing on the ramifications of the financial crisis on world financial markets.  I made many friends in the Ukraine and am deeply concerned for their well-being.  That being said, from an investment perspective, I am not losing any sleep over events in the Ukraine.

 

 

 

 

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