Chris Menon argues that the two are fundamentally different.
This article forms part of our Duelling Fools feature on 'Is Investing Gambling?'. Don't forget to read the opposing argument and cast your vote.
When I accepted this Foolish duel, I did so rather nervously, aware that while the logic of my case is clear, in practice things often appear a great deal more complicated.
Indeed, I'm willing to concede that the line between investing and gambling may sometimes appear to a rather thin one. It's only in hindsight, that we realise we've been reckless and gambled.
What is the difference?
Well it isn't to be judged purely on the basis of your results; whether you've made or lost money.
What really distinguishes gambling from investing is the methodology used to allocate your capital; the amount of research you conduct and the degree of risk you're taking on.
Famous definition
At this point I'm going to quote far wiser heads than mine. In 1934 Ben Graham and David Dodd gave this definition of the difference between 'investing' and 'speculation' in their book Security Analysis:
"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
On this basis, is it easy to see how many so-called stock market investments are in effect speculative punts. For if you haven't done reams of research to ensure that you understand the business you're investing in you stand a very good chance of losing some or all of your capital.
Criteria for an investment
I'd argue that if you don't take the following minimum precautions before buying a share you're speculating not investing:
- Read the report and accounts and try to run a few ratios.
- Try and obtain broker reports on the company.
- Seek out information from your peers and peruse the bulletin boards for gossip about the company.
- Treat tips from any source only as information to be tested against your own rigorous analysis and research.
- Analyse the company announcements to see if they make sense against what you know of the business and the sector.
- Find out who the major shareholders are and try to ascertain what their thoughts on the company are.
- Try and put a figure on the intrinsic worth of the business, which is usually done on the basis of the discounted present value of an investment's future cash flow.
Now I realise that all this at times seems like too much hard work. So, like most people, I often cut a few corners and buy a share I'm only 75% certain of. The result is that I often spend countless hours fretting over the daily share price, instead of enjoying life.
Yet, I'm fully aware that by so doing I've entered speculative territory, taking unnecessary risks purely because I can't be bothered to do the groundwork.
Investment risk
Of course, even investments carry a certain degree of risk. However, in making an investment you have tried to deliberately minimise these risks and buy cheap in order to create a 'margin of safety' for any mistakes you do make. Graham argued that is a company is trading below 67% of its net current asset value per share it is probably worth investing in -- subject to the usual caveats.
Then, if a profit warning does come out of the blue, the chief executive resigns for some strange reason or the market crashes and the price of your share sinks, you have made yourself some wriggle room should you wish to sell.
However, if you've really done your homework and made a sound investment you'll be less concerned by short-term share price movements, confident that the intrinsic worth of the business will eventually be recognised.
> So is investing gambling? Vote now in our Duelling Fools poll.
