Are you speculating in stock or investing in a company? That may sound like a confusing question, but it is an important distinction. This can get you in trouble if you don’t know the answer.
First, let’s be clear that either answer is okay. The problem arises when investors confuse one with the other. As an example, they start out speculating on a particular stock then change to investing in a company when the stock price drops, and they want to get back to even.
Let me explain the difference between speculating in a stock and investing in a company.
If You Speculate in a Stock:
- You are buying because you sense a price movement for some reason (through technical analysis, market/sector news, and so forth).
- You are interested in profiting from a price movement and, most likely, selling and moving on to another stock.
- You have no real interest in the company that issued the stock other than it is in the right place at the right time.
If You Invest in a Company:
- You have done a thorough analysis of the company and believe it has long-term growth potential or undervalued assets.
- You have analyzed the balance sheet and concluded that the probability of a large loss is unlikely.
- You understand what the company does and its sustainable competitive position in its market.
- If the price drops, you know why and can determine whether this is a short-term situation or a change that will have a long-term impact on the stock’s price. A person who buys a stock is more precisely a speculator, while a person who buys a company is an investor. A speculator may not hold a stock very long or may hold it a long time, depending on its performance. An investor buys a company with the intent of holding on to the stock for a long time.
When Things Go Bad
As long as the stock’s price is performing well, neither the trader nor the investor has much of a problem. However, when the stock’s price starts falling, that’s another matter. The smart speculator has an escape plan in place to prevent small losses from becoming big losses. The speculator has no emotional attachment to the stock, so getting rid of the loser at a predetermined point is easy.
Many speculators find that dumping a stock when it has fallen 7% or 8% is a good way to keep losses small. If you set your sell level higher, you are in danger of letting a normal market blip trip your sell signal, only to see the stock and market rebound.
The problem arises when the speculator decides to like the stock and not give it up so easily. The speculator becomes an investor.
The problem is speculators usually don’t know enough about the company to make intelligent decisions about whether to hold the stock or let it go. They are no longer smart speculators and they aren’t smart investors. Any decision they make as an investor at this point will be a guess.
The investor is probably better off when things go bad, but only if you have the courage of your convictions. If the stock price drops, reassess the company and the market.
Did you miss something? Has something changed? Or is now the time to add to your holdings?
Don’t jump on the “sell at 7% loss” rule if you truly believe in the company’s long-term potential. If you become a speculator at this point, you are robbing your future.
What to Do
Aside from having criteria to source trading ideas, speculators should do five things:
- Define an exit point for a loss.
- Define an exit point for a profit.
- Decide whether to set a time limit on the trade, where the sale happens regardless of the size of the gain or loss.
- Then, follow the rules.
- And, keep a journal to analyze how well the trading rules work.
Note that the exit points don’t have to be a fixed price per share. They can run off of moving averages or other technical criteria. Time limits can be useful if your initial reason for entering the trade is that something will happen shortly – earnings, a merger, rumored regulatory change, whatever. When the reason for entering the trade is wrong because enough time has passed, exit. This applies to day-trading short-term market movements as well. If it hasn’t worked in the expected time frame, exit.
Discipline is important in this because it forces the speculator to be careful in the initial thesis. If the thesis proves false, exit. Look for other ideas. Record the reasoning in a journal, so that strategy adjustments can be made bloodlessly when the market is closed.
It’s not that much different for investors. Aside from having criteria to find companies to buy, investors should:
- Decide on what events would change opinions, i.e., the investment is a mistake.
- Decide on what price would make it irresistible to sell because of overvaluation.
- Analyze from a portfolio context when positions would be added to or reduced.
- Follow the rules.
- Keep a journal to analyze how well the investing rules work.
The only real difference is that investors don’t care as much about time. Also, the sale criteria can vary based on P/E, Price/Book, EV/EBITDA or other fundamental valuation ratios. Or, it can be relative to the other opportunities that the investor sees—sell to buy something materially better.
It is okay to be either a speculator or an investor, just don’t try to be both with the same stock.
Edited by David Merkel