“Calling someone who trades actively in the market an investor is like calling someone who repeatedly engages in one-night stands a romantic.” ~ Warren Buffett
When you ask someone about their investments, you will likely hear many different answers…education, exercise, spending time with family, real estate, collectible items and of course, securities, like stocks and bonds.
An “investment” is used as a buzz word to encompass many different things. So what is the definition of an investment? In my mind, an investment is parting with a resource in the short term to earn a return over the long term.
Participating in the stock market is often seen as an investment. And yes – historically, investing in the stock market over the long term has proved to be a fantastic investment. However, the point I am trying to make here is that just because you own a security does not necessarily mean you are investing. Buying and selling securities in the stock market in the short term is not investing. So what is it?
Different Risk Activities
I recently read a book called “What I Learned Losing a Million Dollars.” The author distinguishes between the different types of risk activities. In addition to investing, which was already explained above, the book talks about speculating, trading, betting and gambling…
Speculating is parting with capital in the expectation of short term capital appreciation. You are buying to resell for more than you paid (i.e. buying a house, a stock, or a collectible, with the hope of flipping it).
Trading is similar to speculating. However, I view traders as professionals who set up systems to operate when certain criteria are met. If X happens, do Y. With trading, a lot of activity often happens in a short period of time: months, weeks, days, hours, minutes, seconds, microseconds. Yes microseconds – that’s a millionth of a second. In “Flash Boys”, Michael Lewis talks about High Frequency Trading. He uses the example of a firm who spent $250 million to straighten the fiber optic cables between Chicago and New York to shave 1.4 milliseconds off its transmission time to make trades. Traders often seek profits by making a lot of little trades, whereas speculators generally look to make money on fewer deals.
Betting is an agreement between multiple parties, where one predicts one outcome, and another predicts another outcome. Betting is about being right – your ego is on the line.
Gambling is a form of betting. The key distinction is that the gambler is seeking entertainment, while the better wants to be right.
What was I doing?
“You should not approach the markets as a game to win. Participating in the markets is not about egos and being right or wrong, and it’s not about entertainment. It’s about making money. And if your plan is implemented properly, it’s actually quite boring waiting for your buy/sell criteria to materialize. The minute it starts getting exciting you are gambling.” ~ What I Learned Losing a Million Dollars.
Most people who think that they are investing are probably speculating. And most people who think they are speculating are gambling.
The above statement could not me more true for me. When I first started out participating in the markets, I thought I was investing. Despite having a long term time horizon, I was hoping for short term capital appreciation and some excitement. I wasn’t buying and selling on a daily basis, but I was buying something and then likely selling it within a year. So I was more of a speculator and a gambler than an investor.
As a rule of thumb, if you are trying to gain off of volatility, you are trading / speculating. If you are trying to gain off of long term trends, you are investing.
The chart below shows the S&P 500 over the last 30 years. Participating in the market and benefiting from the upward trend over time is an example of investing.
The chart below shows the S&P 500 over the last 6 months. Trying to gain off the volatility is either speculating or trading.
There is nothing wrong with speculating or gambling if that’s what you are wanting to do. But like Warren Buffett alluded to in the opening quote, don’t fool yourself (like I did initially) into believing you are investing if you are actively speculating or trading in the market.