Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one hell of a party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
— Warren Buffett
In my previous article on process mistakes that are discussed in my book Excess Returns: A Comparative Study of the Methods of the World’s Greatest Investors I briefly described the fundamental difference between investing and trading and why both approaches should not be combined in an investment strategy. An equally common (and equally devastating) process mistake that top investors unanimously point out is speculation instead of reasoned investing. Here under is an excerpt from my book describing the difference between speculation and investing.
Investors must understand the difference between speculation and investing. Speculation can be defined as playing the markets based on hunches, rumors, hope and wishful thinking. Speculators don’t care about the fair value concept. Their only goal is to unload their stocks on unwary buyers at a price above their own purchase price.
Speculators believe in the Bigger Fool Theory, which says that paying a foolish price for a stock (i.e., more than its fair value) makes sense if one can expect that someone else (a bigger fool) will later be willing to buy the stock at an even higher price. As such, speculators feel no qualms about buying fundamentally weak stocks if they can see a reason that someone else will later take the stock out of their hands at a higher price.
An example of a speculation would be the purchase of a stock in anticipation of a takeover (which may never happen), or in the belief that management will do something special. Another example is the purchase of very expensive stocks during a market bubble.
Although speculation can be rewarding over short periods of time, it seldom pays off over the long term. Speculation becomes very dangerous once people begin to take it seriously. And it is at its most destructive when it looks easiest.
As Warren Buffett states in the quote above, the major problem with speculation during a market frenzy is that it is extremely difficult to know when to call it quits. Most speculators get caught in the down draught when the bubble bursts. Even outside of market bubbles, speculation is outright dangerous, because it is not based on a sound philosophy and style. Warren Buffett is convinced that nobody is smart enough to make money from buying stocks one actually doesn’t want with the aim to sell them to other people.
It should be clear by now that speculation has nothing in common with investing and that people should never delude themselves that they are investing when they are speculating. In fact, as illustrated in the following table, the profile of a typical speculator is totally different from that of a true investor.
To read more on the various mistakes that top investors warn for and to find out the surprising similarities in the way these top stock pickers proceed in all the steps of the investment process, I refer the readers to my book. A book presentation is also freely available on SlideShare. In addition, to purchase this book with a special 20% discount for ValueWalk readers use the following promotional code when checking out at the Harriman House online bookshop: EXCESS20 (available in Hardback, Paperback and as an eBook).