Building your personal wealth for retirement through picking stocks should make you an investor. Acting like a speculator but thinking you are an investor exposes your money to risk – check these 4 signs to ensure you optimise your returns.
1. What analysis do you do before you trade?
- Value investing should be based on reviewing a company’s fundamentals to give you a view on what the share is worth, then you can compare it to the current market price and decide if there is a buying opportunity. This analysis might include Discounted Cashflow models, Earnings Per Share valuation (one of Ben Grahams favourites), Book Value evaluation, financial statement review (P&L/Balance sheet/Cashflow) over a reasonable time period (such as 5-10 years).
- Remember you are looking for amazing companies, then wait for Mr Market to offer a ridiculous price.
“Often, the price quoted by Mr. Market seems plausible, but sometimes it is ridiculous. The investor is free to either agree with his quoted price and trade with him, or ignore him completely. Mr. Market doesn’t mind this, and will be back the following day to quote another price.” The Intelligent Investor by Benjamin Graham
- Speculation ignores the underlying company fundamentals and makes a trade based on assumptions in market price movement. This might be informed by technical analysis looking for momentum in the price, market news relating to the industry, or a range of other factors based on the traders experience.
- The speculator is only interested in what other traders are doing and how that affects the direction of share price movements in the short term. This is clearly impacted by individual emotions in the short term rather than longer term corporate earnings.
2. How risky is the trade?
- Risk is often mis-understood on most investing websites, with speculation often cited as being linked to higher risk. However professional traders will always hedge their risk and limit the downside of any strategy, knowing that they will often be wrong.
- Amateur investors, like you and I, introduce massive risk when we take a position assuming a profit in only one direction – and requires the whole of our investment thesis to be right.
- You can reduce your risk by introducing a margin of safety – work out your estimated intrinsic value and only buy 25-50% below that. No model you do will be completely accurate, so you need to assume a level of error. This also allows part of your investment thesis to be wrong without undermining the whole trade idea.
- If you make a trade where can you lose money if your assumptions are slightly wrong, it is likely that you are speculating.
3. How long do you intend to hold the stock for?
- Warren Buffett is often quoted as saying his favourite holding period for the right stock is “forever”
- If you are thinking of making a trade on the intention of selling within weeks or months then this is a classic sign you are speculating.
- High Frequency Traders (HFT), investment banks and day traders might make money with short holding periods, but chances are you won’t. A discussion around whether HFTs are investors or speculators can be found here.
- Find quality companies, buy at a good price, and hold for the long term.
- The only exception to this is if the reason you invested changes, like you find out something new or the company deviates from your investment thesis. If this happens you should consider selling.
4. Do you document your investment rationale?
- Having a clear documented rationale for making an investment will ensure you apply a process to your investing, considered a balance range of facts each time.
- If you make a stock purchase based on the latest trend on the internet or tv that day, its likely you will forget why you made the purchase, struggle to decide when to sell, and lose money on the way down. For a great article on why the media is biased towards speculators check this article.
To clarify, speculating in the markets is not better or worse than investing. However most participants in the markets today are speculators and use highly sophisticated systems, processes and hedging techniques that you don’t have. Put another way, playing the same game as the big boys (hedge funds, investment banks HTFs etc..) will lose you money, it is a zero sum game and they have been playing longer than you.
Your only advantage is to find great companies, trading at below their intrinsic value, with a large margin of safety, then hold and wait for Mr Market to recognise the true value of your find. This takes discipline, training and tendency to take the contrarian view.