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Investment, Speculation, and Gambling

     What exactly are the definitions of the terms "Investment" and "Speculation" and how can investors differentiate the two? Despite the diligent efforts of some of Wall Street's greatest minds, there are no universally accepted definitions. Some securities are referred to as speculative despite the fact that logically, they can be viewed as investments. Additionally, investors frequently buy and sell securities like treasury bonds (that are considered safe investments by most) with entirely speculative motives. Adding to the confusion is the fact that in both the short and long run, investors frequently lose money while speculators frequently make money.

     Legendary investor Benjamin Graham considered the distinction between the two so important that "Investment versus Speculation" is the title and subject of the first chapter of his classic book The Intelligent Investor. According to Graham, "The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. We have often said that Wall Street as an institution would be well advised to reinstate this distinction and to emphasize it in all dealings with the public. Otherwise the stock exchanges may some day be blamed for heavy speculative losses, which those who suffered them had not been properly warned against."

     In 1934, Graham and David Dodd addressed the issue and offered a definition of "investment" in their classic text 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."
     Graham and Dodd's Security Analysis (original 1934 edition)

     One of the most thorough discussions of "speculation" appeared in the Fall 1993 issue of the Journal of Portfolio Management and was authored by Martin Fridson (author of It Was a Very Good Year and Investment Illusions). In "Exactly What Do You Mean By Speculation?" Fridson addressed numerous definitions of "speculation" and discussed some unique and intriguing aspects of the debate. Fridson's "Compendium of Definitions of Speculation" included no less than 20 interpretations from assorted text books, dictionaries, encyclopedias, and other books. Fridson divided the definitions of speculation into four categories. The definitions either implied the use of or involved (1) price changes, (2) quick profits, (3) high risk, or (4) some combination all three elements.

Speculation: The activity of forecasting the psychology of the market.
Speculative motive: The object of securing profit from knowing better than the market what the future will bring forth.

John Maynard Keynes in The General Theory of Employment, Interest, and Money

One interesting issue is the fact that bond rating agencies commonly use the term "speculative" when rating bonds. This issue presents the question: Is buying a junk bond speculation or investing? The answer, of course, depends on your definition of the terms and in this case its important to examine exactly what the ratings represent. Bonds rated lower than BBB by Standard & Poors (or Baa by Moody's) are frequently associated with the term "speculative" (or "junk"). With S&P, the term "speculative" refers specifically to the entities "capacity to pay interest and repay principal in accordance with the terms of the obligation." The rating is not meant to imply anything about the bond's price and makes no recommendation regarding its value and whether an investor should buy or sell the security at any given price.

The use of junk bonds increased dramatically in the 1980's and Michael Milken initially became famous by marketing the securities on an unprecidented scale (and earning hundreds of $ millions for himself in the process). Milken cited research by W. Braddock Hickman from 1958, but according to Fridson arguments in favor of high yield bonds can be found from as early as 1904. The rationale for high yield bonds is that their higher yields more than compensate for their added risk. Therefore a strong argument can be made that junk bonds are better investments for some investors than other less risky bonds.

There are any number of other scenarios that present similarly interesting questions.

Taking the debate a step further, Fridson suggested viewing speculation in the context of "Modern Portfolio Theory." Building on the work of Harry Markowitz, William Sharpe, and others, Fridson concluded that "The common thread between speculation (as currently defined) and transactions that seem speculative, yet fail to satisfy all the established criteria, is that they are all bets against the consensus view." In offering a new definition of speculation, Fridson proposed the term "subdiversification" to describe all deviations from the market portfolio. A portfolio can consist of all asset classes or a single specific asset class. Having introduced the new term, Fridson then offered his definition of speculation.

Subdiversification: Ownership of a mix of assets other than a fully diversified, market-weighted portfolio.
Speculation: Subdiversification with the intention of earning a superior risk-adjusted return.
Martin Fridson, "Exactly What Do You Mean By Speculation?" Journal of Portfolio Management, Fall 1993

Fridson was quick to point out that definitions can be dangerous and makes two points in attempting to prevent misunderstandings. "First, there is no inherent contradiction in acknowledging that a deviation from the market portfolio in pursuit of capital gains is, by definition, speculation, while rejecting the claim that securities markets are perfectly efficient . . . At any given time, however, judging which securities are misvalued involves a certain amount of conjecture. 'Speculation' is therefore a fair term for attempts to exploit pricing anomalies. Again, it should be regarded as a description, rather than a pejorative appellation. Second, a genuinely usable definition of speculation must take into account that many portfolio managers concentrate within subsets of the universe of assets."

Speculation - "the assumption of considerable business risk in obtaining commensurate gain."
Commensurate Gain - "a positive expected profit beyond the risk-free alternative. This is the risk premium."
Considerable Risk - "the risk is sufficient to affect the decision."
Gamble - "to bet or wager on an uncertain outcome."
Investments by Zvi Bodie, Alex Kane, and Alan J. Marcus

In their textbook Investments, Bodie, Kane, and Marcus argued that the primary difference between speculation and gambling (as defined above) is "commensurate gain." They reason that "a gamble is the assumption of risk for no purpose but enjoyment of the risk itself, whereas speculation is undertaken in spite of the risk involved because one perceives a favorable risk-return trade-off. To turn a gamble into a speculative prospect requires an adequate risk premium for compensation to risk-averse investors for the risks that they bear. Hence risk aversion and speculation are not inconsistent."

It's like a crapshoot in Las Vegas, except in Las Vegas the odds are with the house. As for the market, the odds are with you, because on average over the long run, the market has paid off.
Harry Markowitz commenting on the stock market in "Risk Management: Improving your Odds in the Crapshoot" from Bloomberg Personal (July 1996)

Harry Markowitz certainly isn't the first to compare the stock market to gambling. Analogies and metaphors comparing investments with casino games and other games of chance are commonly used on Wall Street. Humans of course, have a long history of engaging in and developing addictions for gambling. According to Peter Bernstein, the earliest form of gambling may date back to 3500 BC when a kind of dice game called astragali was played.

In Against the Gods, Peter Bernstein discussed gambling in the context of risk. Bernstein traced the history of numbers, probability theory, and the development of people's perception about risk and gambling. According to Bernstein, "Human beings have always been infatuated with gambling because it puts us head-to-head against the fates, with no holds barred. We enter this daunting battle because we are convinced that we have a powerful ally: Lady Luck will interpose herself between us and the fates (or the odds) to bring victory to our side."

At a time when casino's, lotteries, and sports betting are hugely popular, it's easy to understand why people might confuse speculation with investment. Mega resort Casinos have sprouted in the Las Vegas desert (and all over the map) at an remarkable rate over the past decade. Larger and more elaborate casinos pop-up on after the other (i.e., The Venetian, Bellagio, Mandalay Bay, Caesars Palace, Mirage, MGM Grand, Luxor, Hard Rock Hotel & Casino, Treasure Island, and New York, New York) and the demand seems to be never ending.

Lottery games date at least to biblical days. Israel was divided among seven tribes by lot. Christ's robe was given to a lottery winner so it would not have to be cut. The Sistine chapel and its paintings were supported by lotteries. The Italian lottery has been running continuously since 1530. Lotteries are played in over 100 countries.
Richard Thaler in The Winnerís Curse

Perhaps our experiences with lotteries can shed some additional light on humans' obsession with risk. Millions of people are willing to stand in lines for hours just to buy a one dollar lottery ticket with worse than "one-in-a-million" odds. The odds of picking all six numbers in a 6/49 lottery are roughly one in fourteen million and the odds of winning the powerball lottery are roughly one in eighty million. For every one dollar lottery ticket purchased, 40 to 60 cents typically goes into the pot and is returned to ticket buyers. Lotteries are therefore negative-sum games because the total payout is less than what goes into the pot. It's not surprising that some have gone so far as to describe state lotteries as a "tax on stupid people."

On the other hand, as Richard Thaler points out in The Winnerís Curse, "it is easy to rationalize the purchase of a lottery ticket by saying that for a dollar purchase, the customer is paying 50 cents for a fantasy. That's a pretty good deal."

Perhaps it is the fact that the stock market and other investments generally rise over the long term, that draws speculators to investment markets. As Markowitz points out, stocks in general are a positive-sum game since they rise in the long term. But, while an investor purchasing a stock has a positive expected return, his or her expected return relative to the market is zero (before costs). See The Arithmetic of Active Management from William Sharpe for more on this topic. Because investors have the option of investing in index funds, the returns from a specific market (or asset class) and any individual security can be separated. This issue goes to the heart of the passive vs. active management decision.

Let's say an investor measures his performance against the S&P 500. If he chooses to overweight or underweight a stock relative to its composition in the index, is this an investment decision or is it speculation? Similar questions can be asked of other investors relative to their benchmarks . The answers of course, depend on your definitions.

Regardless of how you define the terms, its likely to be a worthwhile activity to estimate your expected returns on both an absolute basis as well as relative to an appropriate benchmark. And if you find yourself enjoying the activity of investing or if you find yourself addicted to the speed and excitement of the trading game, perhaps you should seriously consider whether you've crossed the line between investing and speculation, or worse yet, maybe you are really gambling with your money.

Quotes

"The greatest advantage from gambling comes from not playing it at all."
Girolamo Cardano (Source: Against The Gods)

"A prospect that has a zero risk premium is called a fair game. Investors that are risk-averse reject investment portfolios that are fair games or worse."
Zvi Bodie, Alex Kane, and Alan J. Marcus in Investments

"The mathematical expectation of the speculator is zero."
Louis Bachelier in "The Theory of Speculation" (1900)

"It would seem the difference between investment and speculation is not very clear in the minds of most market participants. At market extremes - after prolonged bullish advances or bearish retreats - the confusion between investment and speculation appears to be universal. . . We have no idea what will happen to the market. . . What is certain, however, is that market participants need to be reminded of Graham's investment/speculation distinction; confusion over the concepts is as widespread as it has ever been."
Dennis Butler (Centre Street Cambridge) in "What Speculation?" from Barron's (9/15/97)

"Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to prevent a lot of money from becoming a little."
Fred Schwed Jr. in Where Are The Customerís Yachts?

"Games of chance must be distinguished from games in which skill makes a difference. The principles that work in roulette, dice, and slot machines are identical, but they explain only part of what is involved in poker, betting on the horses, and backgammon. With one group of games the outcome is determined by fate; with the other group, choice comes into play. The odds--the probability of winning--are all you need to know for betting in a game of chance, but you need far more information to predict who will win and who will lose when the outcome depends on skill as well as luck. There are cardplayers and racetrack bettors who are genuine professionals, but no one makes a successful profession out of Craps. Many observes consider the stock market itself little more than a gambling casino . . . Cards, coins, dice, and roulette wheels have no memory."
Peter Bernstein in Against the Gods

"Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook . . . There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose. . . everyone who buys a so-called "hot" common-stock issue, or makes a purchase in any way similar thereto, is either speculating or gambling. Speculation is always fascinating, and it can be a lot of fun while you are ahead of the game. If you want to try your luck, put aside a portion--the smaller the better--of your capital in a separate fund for this purpose. Never add more money to this account just because the market has gone up and profits are rolling in. (That's the time to think of taking money out of your speculative funds.) Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.
Benjamin Graham in The Intelligent Investor

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