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The Investor versus The Speculator

Investing or Speculating

In the stock markets, the investor and the speculator occupy the same ground but they go about their business in very different ways.

The Investor

The investor wants to own assets on the assumption that if businesses or properties generate returns over and above inflation over time then by owning a collection of these businesses or properties he/she will obtain these returns. Certainly, history has proved that in democratic and pro-business economies, businesses do flourish and returns from businesses, in aggregate, have indeed always been well above inflation in the long term. As corporate earnings rise over time, the value of these business in aggregate also rises to reflect the higher earnings. Share prices (and hence the stock markets) naturally follow suit. Reflecting the rise in corporate profits, improved productivity and living standards among other factors, the long term returns from the developed markets has been in the order of 9-10% per annum.

However, this logic only holds true if businesses quoted on the markets are valued at sensible prices in relation to their earnings and relative to the value on offer in other asset classes. And this is where the real difficulties start for the investor. For if the overall market(s) is over-valued then, even if corporate profits remain healthy, returns to investors can still be poor or negative over extended periods. There is little doubt that stock markets were very over valued at the start of 2000 and this over valuation (and a build up of debt in the system subsequently) led to two major bear markets in the space of eight years and the subsequent decade of poor returns.

Poker Table

The speculator (or trader), on the other hand, cares little about what underpins the long term progress of markets. The speculator is only interested in what other investors are doing and how that affects the direction of share price movements in the short term. And the speculator has ample opportunity. It is well recognised that markets are extremely emotional in the short term - with the wild swings amplifying the changes in underlying business conditions both on the upside (bull markets) and the downside (bear markets). If the prevailing sentiment is bearish, the speculator will try to profit from falling prices and if sentiment is universally bullish he/she will attempt to profit from rising prices. Hence, short term share price movements are the sole focus of the speculator's attention. And the best way to study share price movements is by examining price charts and price trends of one form or another.

The difficulty for speculators, however, is that they are dealing with a zero sum game. As we have already stated, the speculator or trader looks to get a return from the stock market on a short term view. But the stock markets do not create wealth on a short term view. Said another way, the markets are a zero sum game in the short term. It is in the medium to long term that the markets generate wealth as economies and businesses therein grow.

Hence, if markets are a zero sum game in the short term then clearly for speculators, as a group, the sum of all gains and losses must be zero, or negative after trading costs. As Warren Buffett, the iconic chairman of Berkshire Hathaway, again so eloquently put it - stock market speculating is like poker - some speculators win, some lose but no new money leaves the room. Undoubtedly, some speculators can win at playing the short term game but those that do are likely to be either professional traders or private traders that are prepared to put in the effort required to succeed at this game. And the effort and experience required is considerable and is completely under estimated by the ordinary private investor.

The combination of higher costs incurred through regular trading and a lack of discipline means that the majority of speculators are almost certain to lose money over time or, in a constantly rising market, to generate returns lower than were on offer.

A Bias in the System
The added difficulty for many would-be investors starting out is that in order to buy shares they must open a stockbroking account. Stockbrokers, however, by their very nature, are driven by commission income, and must promote active trading, which results in a higher level of speculative rather than investment activity in their dealings with clients.

Even worse, in my view, has been the affects of the introduction of 'Contract-for-Difference' accounts and 'Spread-betting' facilities aided by the progress in technology. These accounts have only served to increase the tools available for speculating and add fuel to the fire. Both facilities provide clients with the abilty to leverage their holdings and to go short (i.e. to sell what you do not own in the hope of buying back at a lower price). The majority of private investors can not handle leverage in the stock markets. For the vast majority of people who open spread-betting accounts, all I can add is that you might as well go down to the bookies. No one questions the fact that it is the punter who always loses in the bookies - and so it is with spread-betting.

Deceptive Advertising by Spread-betting Operators
Speculating in the stock markets fulfils the gambling instincts in human nature. Nonetheless, in my view, the conduct of spread-betting companies in their advertising is nauseous. In their attempts to lure new clients in, spread-betting companies regularly make the claim that you can win in both up markets and down markets. It is deceitful advertising at best and I am amazed no action is being taken by the regulator (in Ireland at least) to better protect the public in this area.

Training is Essential
The simple fact is that there is no easy route to success in investing whether this is in the stock markets, direct property investing or private equity and venture capital investing. At GillenMarkets, our mission is to teach sensible approaches to investing through the stock markets, which includes all asset classes, and we provide follow-on advice via the web site. We recognise that many prefer the greater level of activity that trading (or speculating) provides. However, we make no excuses for highlighting that the trader is dealing with a zero sum game and that the system (stockbrokers and CFD and spread-betting providers) is biased towards encouraging speculation. We believe most people should get training before setting out to invest (particularly in stock markets) and we provide such training at our 1-day investment seminar and through our member's web site.

Rory Gillen
25th September 2009