Don’t Gamble With Your Future: Invest, Don’t Speculate

Source: Thinkstock

Source: Thinkstock

Investors often have a difficult time differentiating between investing and speculating. In this article, I parse out the difference in order to help you avoid gambling as much as possible in your portfolio.

Ultimately, it is impossible to eliminate risk from your portfolio. Virtually every investment decision you make comes with some risk because you are making a judgment on what the future will hold. But the difference between investing and speculating is that investors eliminate as many of the future unknowns from your decision making as possible. Speculators are guessing that something will happen — it is usually an event with a binary outcome, which, if you guess correctly, you will do very well.

In order to explain the difference between speculating and investing let us look at the following three assertions.

  1. Coca-Cola (NYSE:KO) will sell more beverages 15 years from now than it does today.
  2. Coca-Cola will announce positive Q2 earnings results.
  3. Peregrine Pharmaceuticals (NASDAQ:PPHM) will find a cure for cancer.

I took the first assertion from Warren Buffet, who has a lot of confidence in its validity. The assertion is based on several factors, including:

  • Coca-Cola has a long history of increasing its sales.
  • Coca-Cola has universal brand recognition.
  • Coca-Cola sells products that are affordable to virtually everybody in the world.
  • The global population continues to grow, giving Coca-Cola a larger customer base over time.

While there is no logical necessity in any of these statements, history has proven all of them to be correct, and a world in which one or more of them will not hold true is a world that is very different than the one we live in. Therefore, the above statements comprise a very compelling investment thesis — although there is risk that one or more of them won’t hold true, it is very unlikely. Furthermore, Coca-Cola is extremely well-positioned to overcome adversity. For instance, if a new company comes along with a popular product Coca-Cola has the power to advertise, lower its prices, or even buy out its competition. If people start to consume different kinds of beverages, then Coca-Cola can simply change its beverage offerings.

If we look at the next two statements, however, we find that there is much more uncertainty. The first one is simply guesswork. If you are buying Coca-Cola stock because you believe that the company will release strong earnings figures, then unless you have inside information, your insight has limited predictability. Keep in mind that your assertion is competing with dozens of analysts whose job it is to study Coca-Cola. Furthermore, even if you are right and even if analyst estimates end up being too low, who’s to say that the stock will trade higher? We often see the opposite take place, which is why trading earnings reports — as lucrative as it may be — is, in essence, gambling.

Regarding the second one, we know that Peregrine is working towards a cure for cancer. But will it find one? Even if it does, who’s to say that Peregrine will be first or that its cure will be accepted by the FDA? If you buy Peregrine shares based on the thesis I provide, and if you are right, you will probably make several multiples on your initial investment. But if Peregrine fails, then your investment goes to zero. Also keep in mind that you are not the only one betting one way or another on Peregrine’s success. What gives you an advantage over the scientists and doctors that the experts on Wall Street can easily afford to hire? The fact of the matter is that Peregrine is speculative — if you buy shares, you are betting that a future binary event will have a specific outcome.

Given these examples, we can now come up with some basic rules for investing as opposed to speculating:

  1. While we can technically reduce everything to binary “either/or” outcomes, if you are betting on a prima facie binary event, then you are speculating, not investing.
  2. Betting on “micro” events or single events is speculating, not investing. Recall that the investment case that I put forward for Coca-Cola is based on several extremely high probability events.
  3. Short-term theses are inherently speculative in nature. It is much easier to predict that Coca-Cola will be selling more products in several years than it is to predict that Coca-Cola will be selling more products next month.

If you keep these points in mind, then you will not be able to eliminate all of the risk from your portfolio by any means. But at the same time, you will avoid outright gambling, and so long as your investment outlook is simple and straightforward you should do extremely well.

Earlier, we had taken a look at five rookie mistakes that new investors can make and which should be avoided. Here is a recap:

1. Investing before you are ready

Daily advertising tells us that we should start investing immediately in order to give our investments more time to grow. However, there are a few basic steps people should take before walking down Wall Street. You need to make sure you have saved up an emergency fund of at least a couple months of expenses. This should be kept in a readily accessible account, something boring like a savings account. The liquidity will help ensure you aren’t forced to conduct any unwelcome selling in your investment portfolio.

High-interest debt should also be paid off before you begin investing. If you’re carrying around credit card debt with an interest rate of 15 percent, the national average, you can essentially make a 15 percent return (risk free) by devoting your dollars to the debt, instead of stocks. The one exception that is widely agreed upon: If you have a 401k plan with an employer match, you should take advantage of the free money as soon as possible while you build your savings fund and pay down debt.

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2. Not having a plan

You need to know why you are investing. In other words, what financial goals do you want to accomplish with your money? These vary among different people, but your financial goals should be clear, measurable, and attainable. They should also recognize constraints.

Without a plan, investors risk being lured into flavor-of-the-month investments. Far too often, investors will rush into funds with the highest rating — after the oversized gains have already been realized. As the chart above shows, funds tend to underperform their benchmarks after receiving high ratings. In fact, five-star rated funds from Morningstar have the biggest gap over thirty-six months following the high rating.

Individuals shouldn’t worry about every headline they come across on a daily basis, but they should take some time to review their portfolios throughout the year. On a semiannual or quarterly basis, make a thirty-minute appointment with yourself or spouse to consider how your portfolio is performing and if you are on track to meet your financial goals.

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3. Trying to time the market

Unless you’re a day trader, you should not be trying to time the market. With the rise of smartphones and tablets, investors are constantly plugged into financial markets, but that doesn’t mean you should always be doing something with your portfolio. The Average Joe is typically better off with a diversified portfolio built for the long term. Trying to time the market can be disastrous, especially when it comes to stocks.

As the chart above shows, $10,000 invested between December 31, 1993, and December 31, 2013, would have grown to $58,332 if it was constantly invested in the S&P 500. If you missed the 10 best days during that period, the investment would have grown to only $29,111, almost half of the amount if you simply left the money untouched. Critics rightly point out that missing the worst days in the market is even better for a portfolio, but that is a dangerous strategy for most investors.

Even if you rightly time the market and avoid the worst days, you are then left with the agonizing decision of when to get back into the market. You need to know yourself and your limitations when investing.

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4. Expecting too much

The past few years have been extraordinary for the stock market, but investors need to make sure their long-term financial goals don’t depend on lofty expectations being sustained over a long period. Since the Dow Jones Industrial Average made its low of 6,470 on March 6, 2009, the index has rallied about 10,000 points. It has also managed to rally for five consecutive years to make fresh inflation-adjusted highs. The S&P 500, which also made its record low of 666.79 on March 6, 2009, has surged more than 170 percent over the same period.

As the chart above shows, this type of performance is not typical. Between 1926 and 2012, stocks have an average annual return of nearly 10 percent. However, inflation-adjusted returns are only 6.7 percent. Depending on your tax situation, stocks have returned 4.5 percent after taxes and inflation. Cash is the worst place to be over the long term, as it has returned only 0.5 percent after inflation and a negative 0.8 percent after taxes and inflation. Bonds have returned 5.4 percent over the same period, but only 2.3 percent after inflation. Distorting the results even more, bond returns are skewed by their thirty-year bull market that drove interest rates straight down to all-time lows.

Source: Thinkstock

5. Making investments more complicated

Humans have a tendency to make life more complicated than necessary. The same is true about investing. There is already plenty of risk that comes along with investing, but many people complicate matters by using leverage.

“When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious,” explained Warren Buffett in his 2010 shareholder letter. “But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

Leveraged exchange-traded funds are a relatively new financial product that most long-term investors should avoid. They are like regular ETFs laced with greed and impatience, and attempt to deliver multiples of the performance of an underlying index or benchmark they track. Leveraged ETFs seek to magnify returns by using some of Wall Street’s favorite financial drugs: derivatives, futures contracts, and swaps. They can also come with higher fees. When it doubt, keep your investing strategy simple and steer clear of complicated vehicles that are more designed to benefit the people selling them.

Disclosure: Ben Kramer-Miller has no positions in the companies mentioned in this article.

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