Confuse the two and you're in trouble!
Every time I feel a desire to impulsively buy a share that I'm convinced must rise (despite not having done sufficient research) I forcefully focus my thoughts on the difference between investing and gambling (or speculation).
Usually this involves reading a paragraph that hangs on a wall by my computer, containing these wise words from Warren Buffett:
"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs."
It reminds me of a time, during the dotcom boom, when I thought I was a pretty smart investor. It took me a few more years before I realised that I'd just been a pretty fortunate gambler -- by which time my luck had run out.
What is an investment?
Ben Graham is considered the father of value investing. In "Security Analysis", he gave this definition of the difference between 'investing' and 'speculation'.
"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 so many so-called stock market investments are, in effect, speculative punts. 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.
Of course, there is an element of risk inherent in buying any share, but the job of an investor is to minimise it to a relatively safe level. The most dangerous situation you can possibly be in is to be gambling when you think that you are really investing.
What should you do to safeguard against this error?
The most important thing to realise is that, because of the imperfect world in which we live, price has nothing to do with value.
Valuing a share is difficult though and there are various methods you can use. It's beyond the scope of this article to go into these in more detail, but suffice to say valuation is not an exact science -- which is why so many people who appreciate the theory of value investing are unable to successfully put it into practice.
Protect yourself
Given that the line between intelligent investing and speculation can be a relatively thin one, there are other ways to guard against making serious errors in judgement.
Here are a few:
- Never invest more in stocks than you can afford to lose.
- Do lots of research and generally wait at least six months from hearing about a stock before you seriously consider investing.
- Never buy a 'hot' stock because of a tip.
- Ask yourself why this stock is better than any other and continually play devil's advocate.
- Guard against your own weaknesses -- especially if you have a high tolerance for risk or are prone to mood swings. The best investors like Buffett seem to be very down to earth and stable individuals.
- Read books by and about knowledgeable investors -- people such as Warren Buffett, Sir John Templeton and Peter Lynch. They have demonstrable experience and expertise in investing. (These books are obtainable from the Fool Bookshop)
- Buy very cheaply, if possible way below net asset value. That way, even if the stock goes down, you have built in some margin of safety.
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