While you contemplate a major investment decision, you need to ask yourself if you will be making a value investment or a speculative investment. You can use Benjamin Graham’s extensive writing about the difference between value and speculative investments to categorize potential investments you are considering.
Speculative investors bet on the Yankees in a Vegas casino. When the Yankees are on a hot win winning streak, the speculator can double his investments after each victory, but when the Yankees’ bats turn cold, the speculative investor will be walking the streets hat in hand.
Value investors buy bonds for Yankee stadium’s construction.
Speculative investors buy a stock with a hunch that the price will go up or down quickly. Value investors buy a stock after determining the long-term value of the business.
Although value investors outperform speculative investors in the long-run, value investors do not expect to outperform the market. Value investors accept the reality that no one can predict market behavior; instead, value investors work to control their own investment behavior.
Benjamin Graham’s 3 Types of Value Investments
1) Well established investment funds – examples are 5-star Morningstar mutual funds, corporate bond funds, & municipal bond funds.
2) Common trust funds (separate accounts) – High net worth investors can hand their portfolio over to a commercial bank or investment firm that will responsibly manage their money on a one-to-one basis.
3) Dollar cost averaging – Deposit a consistent amount of money at specific intervals (monthly or quarterly) into your portfolio. The easiest way to dollar cost average is to buy a mutual or bond fund (from Vanguard for example) where you can setup automated deposits – this way you don’t have to pay trading fees for buying new stocks or bonds every investment cycle. Suze Orman offers a dollar cost averaging calculator on her website.
Benjamin Graham wasn’t alive to see the days of Exchange Traded Funds (ETFs) but I would add ETFs as a fourth value investing option:
4) ETFs – ETFs allow you to buy a stock index (i.e. SPDR S&P 500 ETF – SPY) or a weighted stock sector (i.e. Ultra Basic Materials – UYM). The advantage of ETFs, is that you can buy a diversified investment without having to pay the associate trading fees if you bought a number of stocks, and the ETF management fees are considerably lower than their mutual fund counterparts, about .1% vs. 1.5% respectively.
Benjamin Graham’s 3 Types of Speculative Investments
1) Trading in the market – Shorting stocks that have had a short-term run-up in price.
2) Short-term selectivity – Buying stocks with upcoming earning releases that the speculator believes will beat Wall Street estimates.
3) Long-term selectivity – Picking stocks with high returns in the past, or stocks with promising product releases like tech and drug companies. A risk of “long-term selectivity” is that the speculator may buy a company with an upcoming product that eventually undersells or never makes it to market. Or the speculator’s estimates were correct, and the firm’s upcoming product is a hit, but the previous market price already consider the product’s success. Or even though the speculator’s assessment was correct, he could suffer from the John Maynard Keynes’ proverb, “The market can stay irrational longer than you can stay solvent.”
In between value and speculative investing are “special situations.” A prime example is investing in merger & arbitrage opportunities. Companies announce mergers for shareholder approval far in advance of any formal agreements. The announcement includes a suggested buyout price, and there is usually a spread between the market price of the company being purchased and the suggested buyout price. Immediately in response to the announcement the spread between the market price and buyout price begins to close. However, up until the day that the deal is finalized (or canceled), the spread fluctuates based on investors’ assessment about the likelihood that the deal will be completed. A recent example of a successful M&A closing is 2008 purchase of Anheuser-Busch by inBev. As close as two months before the deal closed, the merger spread widened on credit concerns, causing Anheuser-Busch to sell at $64.86 a share, while the buyout offer stood at $70 a share.
Do you find that you are more of a value investor or a speculative investor?
I find that my natural inclination is to be a speculative investor. So before I make a trade I ask myself how easily I will be able to sleep at night, or as Benjamin Graham puts it, I ask myself if the trade promises “safety of principle and a satisfactory return.”