Adam J. Davis’ Blog

Are you more Warren Buffet or riverboat gambler?

The reason I ask is that what you might think of as investing is really speculating and the consequences could be disastrous for your financial future.

I might be starting an argument of semantics, but I guess that’s the whole point, right?

Anybody familiar with the 1987 film Wall Street is likely familiar with the following quote made by Gordon Gekko, whom I believe summarizes the difference between investing and speculating:

“The public is out there throwing darts at a board, pal. I don’t throw darts at a board. I only bet on sure things.”

This quote is symbolic of what differentiates investors from speculators. Investors buy because they believe the asset they are purchasing is undervalued and/or is likely to increase substantially in value AND the performance of the asset, independent of others’ perceptions, will provide a significant enough return to justify the risk taken and opportunity cost to purchase.

Speculators, on the other hand, buy an asset because they believe they can likely sell it at a higher price (or sell it and buy at a lower price) to another person. The decision making is mostly determined by the appetite of others for the asset and does not largely depend on the characteristics of the asset itself.

Simply put, investors buy because they believe an asset holds value in and of itself and speculators buy because they believe they can offload it to somebody else for a profit.

You are going to notice that the undertone of this post is heavily influenced by the writings and teachings of Warren Buffett and Ben Graham (Buffett’s teacher at Columbia).

1. Good Investors Make Money Independent of What Others Think Of The Investment

A good investment will yield returns to an investor despite what the market thinks of the investment at a given point in time. Let’s look at investment real estate, for example.

A speculator might look at single family homes in Metro Detroit as a bad idea right now, because they could not (at least not very easily) just buy a house and sell it to someone else at a higher price with the ease that they could of 3-4 years ago.

An investor, on the other hand, might look at single family homes in Metro Detroit right now as a good investment. With a rock bottom purchase price and monthly cash flow, the investor would get a solid return over time no matter what happened with retail home prices

2. Investors Do The Work Up Front - So They Don’t Have to Worry About The Back End

Have you ever heard the phrase: “you make money when you buy, not when you sell?” I think this phrase better captures the mindset of the investor versus the speculator. A speculator is always buying because they believe that they can sell the asset to someone else. But, what happens when the buyers dry up? My first guess would be that they would be stuck with an overpriced asset.

Think about the condo developers and ’spec’ home builders across the country right now that are hemorrhaging red ink. Many of these builders continued to build in spite of the supply and demand of basic economics staring them in the eye. They just kept building and building, betting that someone from somewhere would come and buy the house or condo. Credit this as a large part of why housing and condo prices are plummeting across the board in what were formerly hot markets across the U.S.

3. Investors Know That The Market Will Always Fluctuate - So They Insulate Themselves From It

If you actively buy and sell stocks, stock options or futures, what would happen if the markets blew up suddenly? What I mean by ‘blew up’ is that there was some global geopolitical event that shook the foundations of the markets down to their very core. What if there was an oil embargo on the United States? What is there is a terrorist attack on U.S. soil (like Sep. 11, 2001)?

These wild market fluctuations are more likely to happen than not (causes could vary). Speculators constantly have to change their strategy to capitalize on market fluctuations, their very survival depends upon it. Investors don’t have to worry about this, they know that the asset they bought has a fundamental value, based on it’s intrinsic characteristics that will generate returns independent of the turmoil of the financial or real estate markets.

4. Investors Can Have More Control

Investors can have more control over their investments than speculators. How? Because the speculator is always worried about what the market will do that they have added another variable into the equation of investment performance. The only variable the investor has to worry about is whether or not the asset was a good buy at the price they are paying. The speculator has to always worry about what the next guy will pay.

There is another way that investors can have more control, too. Let’s turn to real estate again as an example. If I purchase a piece of commercial real estate, say a strip mall, I can make money from the rents on the stores alone. I can also do things to increase the cash flow, such as remove certain types of stores for more appealing ones, bring in larger tenants, increase parking, etc. All of these things are in my control to increase the performance of my building (and hence increase my ROI) and are not dependent on what other people think it is worth. I have more control to drive my investment performance.

A speculator, in this scenario, would only think about what he could sell it to the next person to and would likely not invest as much in driving the cash flow performance of the asset as an investor would. Time frames for holding make a large psychological difference.

5. Investors Enjoy Better Tax Treatment

The longer you hold and investment, the better the U.S. Government will treat you when it comes to taxes. Speculators (the ones that make money) incur short term profits each time they trade during the year. This results in ordinary income tax treatment of all the profits made.

Investors, on the other hand, usually hold their investments for longer periods of time (they are focused on the asset performance, not the markets pricing of the asset). Investments held for longer than 1 year are treated at lower tax rates in the U.S. (capital gains versus ordinary income). Dividend and passive income tax rules will often apply as well, throwing further tax benefits in the direction of the investor and not the speculator.

Now, I am not saying that there are no speculators that do well financially. Quite the contrary, I know several stock speculators that do well, year in and year out. It just may be in your blood to be a speculator. However, it has been my experience that investors make more money over the long term and build more substantial net worths because they pursue assets that will generate returns no matter what the market says the value of the asset is worth.

I realize that I could be throwing down the gauntlet in a lot of areas here: efficient market theory, value investing versus growth investing and many more. If so, I am quite glad. Let the debating begin.

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