|
In this respect Telstra is hardly unusual: analyses similar to the one set out a
fortnight ago would show that virtually all Australian “blue chip“
shares are significantly overvalued. If so, then little investing and much speculating
is currently occurring on the Australian Stock Exchange.
In this report I pursue two implications of the 1 November report: first, the
key difference between investing and speculating; and second, the reality that
the returns from investing virtually always (when applied to the securities of
excellent companies purchased at sensible prices) exceed the returns from speculating.
Investment and Speculation
Benjamin Graham hit the nail on the head: the basic difference between investors
and speculators lies in their attitude towards market prices in general and short-term
price fluctuations in particular.
Speculators look at a security (a stock, bond or title to a piece of real estate)
as no more than a piece of paper, and regard its intrinsic value and market price
as synonyms. They focus almost exclusively upon “the market“; ignore
the economic fundamentals of the business which underlies the security; and try
to anticipate short-term price trends and fluctuations. Investors, in contrast,
distinguish between a security’s market price and its intrinsic value. They
focus upon the economic fundamentals of the business underlying a stock or bond,
and pay attention to the volatility of its price only to the extent that it enables
them to buy at reasonable or bargain prices. Speculators thus tend to buy and
sell in rapid succession; investors, in contrast, intend to buy and hold for the
long term (five years or more).
Graham’s distinction between investing and speculation has important
implications. Most notably, a given security is neither inherently an investment
nor inherently a speculation: its status as one or the other depends upon its
economic fundamentals and purchase price. Accordingly, no matter the quality of
a company’s products and management, at sufficiently inflated prices the
purchase of its shares becomes speculative. Telstra, as I argued last week, provides
a current example. And no matter how poor a company or its prospects, at sufficiently
depressed prices its securities can be a good investment: Warren Buffett’s
purchase of Washington Public Power Supply System bonds, the largest municipal
bond default in U.S. history, provides a textbook example.
The Futility of Speculation
The key to successful speculation is the ability to anticipate the direction
of price trends and the magnitude of fluctuations around those trends. If we were
omniscient and able to predict short-term price fluctuations perfectly accurately,
buying at a low price and selling shortly afterwards at a higher price, we would
clearly make lots of money (we will shortly see just how much). It is precisely
this alluring prospect of huge trading profits – together with a high degree
of confidence in their ability to divine the future – which tempts so many
people to speculate.
Reality check: as alluring as this sounds, in practice it is extraordinarily
difficult, if not impossible, to time one’s speculative purchases and sales
to the standard of precision required to beat the buy-and-hold investor.
Three simple examples show us why. Each graph depicts the prices of two stocks
at 12 points in time. In each example, a speculator can take advantage of 12 occasions
to buy low and sell high.
In Graph1, the two stocks’ trends are identical: prices increase from $1.00 at Time 1 to $1.50 at Time 12. But movements around this trend differ: Stock 1’s
pattern is consistent (i.e., a rise of $0.15 is followed by a fall of $0.08) and
has relatively small price fluctuations; the price of Stock 2, however, fluctuates
more widely and erratically.
In Graph 2, the two stocks’ trends are again identical; this time, however, the trend is for a constant price of $1.00 over the 12 time periods. Again, Stock 1 has
relatively small fluctuations (i.e., a rise of $0.08 is followed by a fall of
$0.08) and Stock 2 has larger fluctuations (i.e., a rise of $0.16 is followed
by a fall of $0.16).
In Graph 3, price trends decrease from $1.50 at Time 1 to $1.00 at Time 12. Again, movements
around this trend differ: Stock 1 decreases consistently (i.e., a fall of $0.15
is followed by a rise of $0.08) and with relatively small fluctuations; and Stock
2 decreases more erratically and with larger fluctuations.
The performance of a buy-and-hold investor is easy to calculate. If either
stock is purchased at $1.00, held until the price reaches $1.50 and then sold,
then (assuming a brokerage rate of 1% of proceeds and no capital gains tax) a
capital gain of $0.50 per share and a pre-tax return of 50% is earned. If either
is bought for $1.00 at Time 1 and sold for $1.00 at Time 12, then the return is – .025%.
And if either is bought for $1.50 at Time 1 and sold at Time 12 for $1.00, then
a return of -33% results.
How would a speculator’s performance compare to the buy-and-hold investor’s?
To answer this question we need to make several assumptions. Assume again that
brokerage is 1% and there is no capital gains tax. Assume as well that there are
three varieties of speculator: the first can identify a price trend correctly
and predict perfectly all deviations from the trend. The second is almost perfectly
omniscient, and can predict deviations from trends to within 5% of their real
values. And least unrealistically, the third is very accurate but imperfectly
omniscient, predicting trends and each of the 12 prices to within 7.5% of their
true values (i.e., to within 10 cents at prices of $1.30).
These assumptions, it is important to note, load the dice extraordinarily heavily
in the speculator’s favour. According to several research studies, there
is no more than a one-in-ten chance of ascertaining when a price is near a high
or low point. To make money, a speculator must make two accurate guesses: one
to buy low and the other to sell high. A perfect speculation thus has no more
than a 1% chance of success. The chance of two perfect speculations in a row is
no greater than a one in ten thousand (1/100)(1/100); and clearly the chance is
doing it successfully 12 times in succession is so small that it is not worth
calculating.
Comparing Investors’ and Speculators’ Returns
Rising
(Reg) |
Rising
(Irreg) |
No
Trend (Reg) |
No
Trend (Irreg) |
Falling
(Reg) |
Falling (Irreg) |
Buy
& Hold |
+
50% |
+
50% |
-
3% |
-
3% |
-
33% |
-
33% |
No
Error |
+
94% |
+665% |
+
54% |
+134% |
+
40% |
+255% |
5%
Error |
+
13% |
+202% |
-
16% |
+
30% |
-
23% |
+
97% |
7.5%
Error |
-
15% |
+112% |
-
38% |
-
5% |
-
44% |
+
42% |
The table sets out the performance of our four actors under these assumptions. Not
surprisingly, the perfect speculator obtains the best returns, ranging from a
minimum +40% to a maximum +665%. The greater the extent of price fluctuations,
the greater the perfect speculator’s results: clearly, perfectly omniscient
speculators should concentrate upon securities whose prices fluctuate as widely
as possible.
 |
| Much more surprising is the finding that in 4 of the 6 scenarios the “dumb“
buy-and-hold investor beats at least one (and sometimes both) of the extremely
smart, very accurate but imperfectly-omniscient speculators. |
|
Most notably, in the first scenario the investor’s return of 50% greatly
exceeds either speculator’s result – indeed, the second speculator achieves
a negative return. And in the third scenario, where the trend is stable
and prices fluctuate little, the investor’s marginal loss is clearly preferable
to the speculators’ much more considerable losses.
The Moral of the Story: Invest, Don’t Speculate
Why then does Leithner & Co. eschew speculation and stick resolutely to a philosophy
of buying good quality securities at attractive prices and then holding them as
long as fundamentals justify doing so? Because even when one loads the dice very
heavily in speculators’ favour, and attribute to them superhuman powers
of prediction, speculative errors of even small magnitudes lead to huge reductions
in returns – returns which are often well below those achieved by buying-and-holding.
In practice, a 7.5% margin of error is a very small margin. If you think that
it is possible to limit predictive errors to this range, read seminal studies
by Amos Tversky, who demonstrates that most people vastly over-estimate their
ability to predict accurately.
In practice, then, poor timing will eliminate any possible gains from speculation.
If we accept that people are incapable of timing their purchases successfully,
then we must conclude that poor returns – and potentially large losses – are
a virtually inevitable consequence of speculation. And yet large numbers of people
consciously and actively speculate. That is why, in addition to the losses which
will accompany speculation, I keep clearly in mind the admonition of Benjamin
Graham and David Dodd: “in our experience and observation, extending over
50 years, we have not known a single person who has consistently or lastingly
made money by ‘following the market.’ We do not hesitate to declare
that this approach is as fallacious as it is popular.”
 
Designed
& maintained by
Artist Web Design
©1999-2013 All Rights Reserved |
