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Are you an investor, speculator, or investulator?

     There is a very worthwhile debate on the difference between investing and speculating that started last week via the CFA web site and is continuing there and at the Wall Street Journal. Some of the strongest investment thinkers of our day have been commenting on a topic that legends in the Field (including Benjamin Graham and John Maynard Keynes) previously had attempted to clarify (without a majority conclusion). This is a topic I started writing about in the 90s (see Investment, Speculation, and Gambling dated 6/1/99, which cites much of the material replicated in the current debate links below).

     I highly recommend all investors, whether they be experienced and educated, or novices (or somewhere in between), give a careful read to the debate and then reevaluate which of their own financial activities fall under the respective definitions. As is often the case, there is something to learn from each of these contributors, but I also believe there is a certain amount of denial by a large percentage of investors that believe they are investing, yet are actually speculating. And it is important to note that the investment industry has evolved significantly in recent decades to the point where this debate can be clarified significantly from the conclusions reached before discount commissions, the explosion of mutual funds, and the recent development of ETFs.

     Of the recent commentaries linked below, I suspect Martin Fridson's will be the most difficult to accept by many. I focused on Fridson's argument in my 1999 comments, and as Fridson points out, his position is unchallenged to his (and my) knowledge. That point is that any movement away from the index of an investment asset class is speculative (whether that be dropping one security from an index or choosing to invest in only one from an index, or anywhere in between). In other words, passive (index) management (in asset classes with positive historical real returns) is investing and active investing is speculative (relative to the passive benchmark). And while passive investing has grown dramatically in the last few decades, active investing remains the vast majority of activity (despite Jack Bogle's contributions in creating the tangible ability for investors to invest passively via Vanguard, and in his writings). I also elaborated on that more recently via my sub-website As Ken French concludes in The Cost of Active Investing, enormous sums of time, effort, and money are devoted to attempting to beat passive investing. Based on French's numbers and data from legal gaming operations, I also pointed out that more is spend on trying to beat the stock market than is spend on legalized gambling in the US.

     Returning to the topic of defining investing and speculating, my suggestion follows along the lines of a combination of Fridson's work with contributions from others including Zvi Bodie, Alex Kane, and Alan Marcus (source), who point out that investing has to have an element of a positive expected risk-adjusted return. In other words, to qualify as investing, the specific activity should include both 1) a theory as to why returns in aggregate and over the long term will produce positive real returns, and 2) empirical evidence that the activity produces positive real returns in aggregate and over the long term. Stocks and bonds (measured by indexes) meet that criteria, but active management does not because we know both in theory (see The Arithmetic of Active Management by William Sharpe) and in practice active managers subtract value (see Odds and Probabilities of success in active management).

     Howard Marks brings up some additional points and we also have to address his performance (and others in the minority of active managers that outperform over extended periods). I do believe there are talented managers that can win despite being speculators. It takes a decent number of observations before you can statistically estimate that a manager is skillful as opposed to lucky, and even if so, many that do well fail to repeat that success going forward. Just as there are managers that seem to be able to beat the odds in some categories (and that I would not bet against), there are also participants that play negative sumgames that I would not bet against. I certainly would not bet against Marks, who has a stellar record at Oaktree Capital and also backed Jeff Gundlach and Doubleline (another example of someone that shows the signs of a skilled investor/speculator).

     Following up on Fridson's argument, my point is that the debate often misses the major development of the last 40 years that has changed the investment vs. speculation debate. That major development is the introduction and evolution of passive funds. Buying a stock is a combination of investing in stock and a bet on the specific company. Buying a stock index fund separates the buying stock, from individual stock picking (thus separating the investment from the speculation). And therein lies the distinction between an investment and a speculation. The investment is buying stocks (which historically return 6.6% net of inflation). Betting on one stock is an investment, but it's also a speculation relative to the index.

     A good follow-up question is whether those that attempt to take advantage of anomalies or "risk factors" are investing or speculating. For instance, if we have both theory and empirical evidence that value stocks and/or small cap stocks have outperformed, then buying value and/or small caps is not speculative by a definition that includes theory and evidence of a positive risk adjusted return. Fridson's raw definition of subdiversification from the market portfolio may define a value or small cap tilt as speculative, yet perhaps a further definition of speculation needs to identify speculation as either prudent/imprudent, or intelligent/unintelligent (with a value or small cap tilt perhaps qualifying as prudent speculation). Additionally, there are other reasonable reasons for deviation from a market portfolio (for instance if a capitalization weighted index has one or more components that make up a large percentage of the index, some would prefer to reduce that exposure).

     Another fair question is whether high frequency traders are investors or speculators. Some define investing as long-term, but I do not. I would consider a true arbitraguer to fall under the investor category - buying something in one location and selling it (or its equivalent) in another for less (thus profiting by the difference). Similarly, I consider market making high frequency traders to be investors as well. Both in theory (you can make money as a middle man between those that buy and sell securities) and in practice, market makers are profitable in aggregate and over time (See The Bid/Ask Spread and Market Making). However, high frequency traders attempting to profit from momentum or trading ahead of presumed large investors is less clear cut.


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