It is common for people who are averse to stocks to label it as speculation. The same people usually believe other asset classes such as gold or real estate to be always safe investments. Are some assets always speculative while others are always good investments?
To answer this question, we first need to understand the difference between the terms investment and speculation, which although appears very obvious, is in reality not so. Benjamin Graham, who is considered the father of ‘ value investing', defined investing as an operation that, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative. Speculation is definitely more risky than investing.
Price vs. value
Graham insisted that an investor must always consider both the price of the asset (in relation to its intrinsic value) and quality of the asset, before investing in it. In fact, I would argue that the price paid in relation to value is the key differentiator between an investment and speculation. Basically what this means is that, there can be no asset that is always a good investment irrespective of the price. Even the highest quality asset can become speculative if the prevailing price is unreasonably high. Similarly, no asset can be permanently deemed to be speculative, as long as there is some underlying value for the asset and there are times when the price is less than this underlying value. By nature of the fact that a stock represents ownership stake in a company, provided the company has an underlying value, a stock can be considered a safe investment — at the right price.
One of the primary reasons behind the global real estate bubble and the subsequent burst that pulled the whole world into recession was the assumption that real estate as an asset is always a safe investment irrespective of the price paid to acquire it. But it looks like the episode has already been forgotten. There are signs of another bubble brewing in Indian real estate, especially in cities like Mumbai, where prices in upmarket areas have touched Rs. 1 lakh a square foot! Even remote suburbs are commanding prices in excess of Rs. 1 crore for a 2BHK. Although people feel that the price may be stretched, based on reasonable estimation of intrinsic value of the property and their own ability to repay the loan, they still go ahead and make the purchase, believing that they can make a cool profit when the price increases further two years from now. A new crop of buyers have emerged who barely have money for advance deposit and count on flipping the property on delivery as an exit strategy. This is called the “bigger fool” game of speculation, which basically refers to purchasing an asset at an unjustified price today for the only reason that it will become even more unjustifiable going forward. The problem with such momentum plays is that you can never be sure if there will be a bigger fool waiting to buy from you, or if you are the biggest fool.
The ongoing IPO rush in the stock market is another example of speculation, wherein one applies for the IPO without the slightest analysis of whether the offer price is attractive, solely depending on listing gains to profit. I am not saying that people don't make money speculating; I am sure there are many who are proud to be speculators and are very good at it, but the risk is in not fully comprehending the risks involved. This reminds me of a line in the movie “Wall Street: Money Never Sleeps” — Bulls make money, Bears make money, Pigs get killed. Similarly, investors will make money and speculators may also make money, those who think they are investing but are actually speculating are the ones who are first in slaughter line.
Thanks to the rampant printing of dollars at near zero interest rate in the United States (or quantitative easing as the Americans refer to it), there is an abundance of cheap money chasing assets around the world — particularly in emerging markets like India and China. As a result, asset prices in our country — be it stocks, commodities, real estate or for that matter even gold, all appear to be moving in the direction of irrational exuberance. Amidst all this hype and action, speculation might seem very attractive but be forewarned that investing by seeking out value is much safer. The good news for investors is that there are still pockets of value left; all you need to do is search harder.
The writer is a finance specialist. He can be reached at email@example.com or www.shyamscolumn.com.