Some Historical Perspective
Long before most people around today were born, there was a time when stocks were not considered “investments”. The only true (and by far the most popular) investments were bonds. Equities were considered pure speculation, or the playground of traders and sharp dealers ready to fleece the unsuspecting.
The shift in public attitude can be largely traced to 1924. In that year, economist Edgar Lawrence Smith published his highly influential study “Common Stocks as Long Term Investments”. Indeed, Mr. Smith had originally set out to prove just the opposite; that common stocks were inferior to bonds as an investment vehicle. But after studying numerous 20-year holding periods, Smith found that a diversified portfolio of stocks consistently outperformed bonds in terms of yields and capital appreciation. John Maynard Keynes, who favorably reviewed the book, largely attributed the outperformance to the compounding effect from profits being reinvested in the businesses.
The concept took hold, leading to the widespread popularity of stocks, and (at least according to Benjamin Graham) was partly to blame for the infamous crash of 1929. A second popular incarnation of the idea gained large traction with 1994’s publication of “Stocks for the Long Run”, by Jeremy Siegel. (Coincidentally enough, the markets took another big hit within a similar time frame to that which followed Smith’s book.)
The Modern View: We're All Investors Now
In any case, the idea has become ingrained in the public’s psyche to the point where there’s rarely any argument over whether stocks are investments or not. Rather, it’s more a matter of just what “type” of investments they are. Among the more widely recognized categories now are income, growth, special situation, and momentum investing. But let’s brush aside the cobwebs of history for now, and look at the original categorizations. To be sure, there are overlapping components to each of them. But stripping away modern labels may give today’s market player a clearer understanding to what the game is all about, and perhaps, how better to play it.
Investing: Pay Yourself First
What exactly does it mean to invest? Where does one draw the line between investing and speculating, or even gambling? Today, the term investment is thrown around rather carelessly, and often at things that don’t deserve to be in this category, frequently as part of some misdirected sales pitch. “Invest in yourself!” Invest in your future!"Or this limited edition collector plate!" Cry the ads. The list of so-called investments is long. Is a house an investment? What about a business, an education, a collectible car, or even Beanie Babies?
Well, the old way was easy to tell. An investment is something that pays you. So is real estate an investment? It can be. If you purchase a house or a building and then rent it out, the answer is yes. Of course, if the income doesn’t cover your expenses, then it’s a bad investment. It can also pay you in terms of providing a place to live, so long as it’s cheaper than renting. There can also be an additional payoff somewhere down the line, if the house is eventually sold for more than it cost (factoring in accumulated expenditures and inflation). But this is not a given, a fact which was hammered home by the recent downturn in the housing market. Instead, this is speculation, which we’ll examine further in a moment.
The same can be said of buying artwork, or any other collectible, and yes, even an education. You may get back what you put in, and maybe more. And then again, you may not. On the other hand, buying a business fits the classic definition. The caveat, of course is that that how “good” an investment depends on how much profit is derived from owning it.
So are stocks an investment? They can be. But again, only if they pay you. And the only real way a company can directly pay you is through dividends. To be sure, other actions that enhance “shareholder value” can be a plus, such as buying back shares or paying down debt. But there’s no guarantee that those moves will result in more money in your pocket. (For a more detailed look at these considerations, see What’s Better? Dividends, Buybacks, or Debt Reduction).
So, bottom line; no dividends, no investment. But, you may ask, can’t stock prices decline and dividends be cut or discontinued? Sure. Then they turn into lousy investments, but investments none the less.
Are “classic” investors a dying breed then? Not exactly. In modern-day parlance, they’re known as “income investors”. And, with interest rates on bonds and savings accounts at historical lows, and uninterrupted capital appreciation a seemingly bygone memory, income investing has returned to the forefront as more market participants seek out dividend paying stocks.
Speculation: Looking Ahead
The word speculator comes from the Latin, literally meaning a spy or lookout. It is derived from specere, which means “look at, see”. In the stock market, speculation has taken on negative connotations over time. But as we mentioned earlier, all equities were considered speculations at one time. You bought them having no idea if, when, or how much they would go up. You were “looking out” to a time when someone else would be willing to pay more for them. You were taking a risk.
In the heady days of the Internet bubble, speculation became rampant, but few were willing to call it that. After all, everything was going up. You couldn’t lose! You simply waited a few months, weeks, or hours and someone else would come along to buy the stock from you at a higher price. Well, as we know now, that all worked out very nicely, until it didn’t.
So, if you buy something with the expectation or hope that you can eventually sell it to someone else for more than you paid, that’s a speculation. The reasoning behind it can be manifold. You think that a stock (house, or collectible) is priced well below market value so you buy it in hope of “flipping” it. Or, you think it may not be worth much now, but there will be some development that will suddenly create some value. That mining company you’re considering could make a huge discovery. The run-down neighborhood across town may be ripe for gentrification. That pitching rookie on the baseball trading card may have the makings of a future hall-of-famer. Perhaps. But we don’t know, so we’re speculating. We believe the price should go up. We certainly want it to go up. But nowhere is it written that it will go up.
This category is now largely defined as “growth”, “value”, or “special situation” investing. This is where the individual is looking (speculating) for something to happen, but which is either currently unrecognized by the market or just isn’t happening yet.
Trading: Going with the Flow
Traders are close kin to speculators, but with two important differences. As we just alluded to, speculators have an idea, hope, or belief where things should go and they’re making their moves accordingly. Traders, on the other hand, aren’t trying to guess (see ahead) where things might go. They’re more interested in where things are going now. Basically, a trader will look for a trend (up or down) and then follow it. When it ends, peters out, or reverses itself, he or she is onto the next trade. This may transpire over a variety of time spans, all the way down to the level of milliseconds in the case of programmed trading. There is no fundamental analysis required. No need to do extensive research and assessment of a company’s past operating performance and prospects. Indeed, in all too many cases, business trends, economic environment, and even the company name may not matter. A stock is either moving or it isn’t. In fact, methods which largely rely on price action (technical analysis), have long-been streamlined to the point where computers can do it better and faster than humans. Thus, automated trading now accounts for the lion’s share of daily stock market activity. At the risk of oversimplification, the markets are dominated by systems following instructions. When ”X” happens, do “Z”.
Another important difference between traders and speculators is that the former are usually looking to make small profits on a lot of little trades, while speculators generally seek bigger profits on fewer transactions.
Which Style Fits You?
If you’re of the sort that listens to and watches the market’s behavior, seeking out an existing trend or situation, and attempting to extract some profit from it while it lasts, then you’re a trader. Or, if you prefer, a momentum-based investor. Time frames and frequencies will vary, of course, according to taste and temperament. You might be looking at issues that have done well over the last few months, weeks, or minutes. Either way, you’re looking to hop on a train that’s already moving, and preferably at a decent clip.
On the other hand, if you buy a stock with the expectation that it will, should, or even “can’t help but” go up, whether in five years, five months, or five days, then you’re speculating. You believe that the market has it wrong and your information or foresight is correct. You are, in a sense, telling the market what it should do. Under the classic nomenclature, you were undoubtedly a speculator. Now, you’re a growth, value, special situation, or turnaround investor.
Finally, with all the above held under consideration. If you only buy carefully selected stocks to collect their dividends with the thought of holding them now and forever (with perhaps a little appreciation down the line), then you, sir, are an investor in the classical sense of the word. That is, until conditions change. Indeed, it would be foolish to continue to hold on to even well-chosen issues if they no longer make financial sense. If the dividend is eliminated, for example, then it no longer fits our definition. If the dividend gets cut, we need to reevaluate whether it’s still worth holding. And, if the price has taken a big hit (relative to the broader market or its industry peers), we need to look into whether it’s worth buying more or selling out altogether. Thus, the classic investor category has morphed into what’s more-commonly referred to today as “income” investing.
