Financial Decisions | Views

Being an investor and not a speculator … and knowing the difference

After a rocky three months in the financial markets, it can be excusable for investors to feel a little nervous. A lot of the nervousness usually comes from the barrage of negative press about the state of the world economies.

Rather than providing commentaries about our view of the economic situation, we believe it can be far more fruitful and important to understand what it means to be an investor rather than being a speculator. Many people however, do not know the difference. Their hearts and minds are often in conflict about what it is they should focus on. As such, many smart people can do dumb things in the financial markets. With a mix of over-confidence in their own abilities, this mix can often be disastrous when it comes to the world of investing.

In this month’s Views, we’d like to highlight some important factors that distinguish between being an investor and speculator.

Investing – The purchase of a long-term ownership of solid businesses and focusing on the cash flow and earnings it can yield over the life of the asset. Quality, valuation and time are the key ingredients.

Speculating – The act of predicting what prices are likely to do over the short term, not taking into account any fundamental analysis of the company’s future. Timing is the critical ingredient in speculating.

What it means to be an investor:

    • Have a longer time horizon – Those with a longer-term investment horizon have an easier advantage and a much better chance of making reasonable returns. It is why we often cringe when asked about what we have done over the past month or quarter. We see many managers end up underperforming when they focus on beating their relevant benchmarks each quarter and suffer what is called the “institutional imperative”. Warren Buffett said, “I have no idea on timing. It is easier to tell what will happen than when it will happen.” As such, being an investor often means you need to be patient to see the more favourable scenario play out.
    • Temperament – Humans all suffer from biases and a difficulty to cut losses. It is important to learn how to cut losses early and let the flowers grow. This is always easier said than done and it takes years of learning and re-learning to enable your heart and mind to act in sync and not get too emotional when you suffer a small loss. We also need to learn and understand the many human tendencies in order to advise wisely. Often, our advisers become educators and provide guidance to our clients, especially during difficult market periods, as this is crucial to the end game of providing you with reasonable returns.
    • Circle of competence – While diversification is absolutely necessary to reduce certain risks, it is also important to acknowledge what you don’t know. We all know that we cannot be a specialist in every sector so we shouldn’t try to be.
    • Valuations – Understand that valuation is an inexact science and it is important not to buy companies at too much of a premium to their estimated value. Even the best company can be a bad investment if you had bought it at a large premium. For example, Coca-Cola took over 13 years to surpass their previous all-time high reached in 1998 when they traded at over 45 times their earnings.
    • Quality – We make sure that clients keep within the high quality spectrum when purchasing company shares, to give themselves the best chance of making reasonable returns over time.
    • Focus on averages – Due to our loss averse nature, humans tend to focus on the individual losses rather than looking at the overall average returns.

We can go on for pages explaining the many subtleties but at the end of the day, it’s not much point understanding the concepts but not knowing how to apply it to your advantage in real life. Yogi Berra, a famous American baseball player, correctly noted, “In theory, there is a no difference between theory and practice, in practice there is.”

Investing is a difficult game to master. It is the reason why many participants become “lazy” to learn, prepare, stay disciplined and patient and strike only when necessary. Instead, most go down the path of speculating, usually resulting in very mediocre returns. Human behaviour almost guarantees that the amateur investor is unlikely to do well in the financial markets due to the natural influence of peers, news and the lack of in-depth understanding. As such, we could argue that the majority of market participants that do not have most of the above abilities are likely to fall into the speculator group.

Too many people forget the value of good advice and guidance when it comes to investing. Choosing a good company to invest in and purchasing their shares is usually the easy part. Monitoring its future earnings, position size, understanding and applying the behavioural aspect of investing to your advantage is usually overlooked but are often even more important during the course of the investment.

Mark Twain aptly summed up the dangers of speculating when he said, “There are two times in one’s life when you should not speculate; when you can’t afford it, and when you can.”

We have warned clients against raising their expectations on market returns over the longer term, usually at a time that many add more risks to their portfolios. The pullback in markets over the past three months remind us that markets do not go up in a straight line and that you will need to accept a lot of volatility to achieve reasonable returns even with a portfolio of solid companies and managers. In light of the historically low interest rate environment (that is likely to persist), we recommend that clients reduce their return expectations on their portfolio over the medium term.

Disclaimer: This publication has been compiled by Financial Decisions (AFSL/ACL Number 341678). Past performance is not a reliable indicator of future performance. While every effort has been taken to ensure that the assumptions on which the outlooks given in this publication are based on reasonable data, the outlooks may be based on incorrect assumptions or may not take into account known or unknown risk and uncertainties. Material contained in this publication is an overview or summary only and it should not be considered a comprehensive statement on any matter nor relied upon as such. The information and any advice in this publication do not take into account your personal objectives, financial situation or needs. Therefore you should consider its appropriateness having regard to these factors before acting on it. While the information contained in this publication is based on information obtained from sources believed to be reliable, it has not been independently verified. To the maximum extent permitted by law: (a) no guarantee, representation or warranty is given that any information or advice in this publication is complete, accurate, up-to-date or fit for any purpose; and (b) Financial Decisions nor its employees are in any way liable to you (including for negligence) in respect of any reliance upon such information or advice. December 2015

Contact: Financial Decisions PO Box 484 Mona Vale NSW 1660, T 02 9997 4647, F 02 9997 7407