Are you speculating in stock or are you investing in a company? That may sound like a confusing question, but it is an important distinction. If you don’t know the answer, it will be difficult to make wise choices when buying and selling stocks.
First, let’s be clear that either answer is okay. The problem arises when you confuse one with the other, or change tactics midway.
Learn the difference between speculating in a stock and investing in a company.
- Speculators seek to profit from price movements, while investors seek to buy an undervalued asset and hold it for the long term.
- The trouble arises if you start out as speculating on a stock but switch to investing in it, because you've lost your coolheaded evaluation of its performance.
- Whether you're an investor or a speculator, you should define your rules for buying, holding, and selling a stock, and stick to them.
Speculating in a Stock
When you speculate in a stock, you are merely hoping for a profit. You are buying because you sense a price movement for some reason (through technical analysis, market/sector news, and so forth).
Because you are only interested in profiting from a price movement, most likely you'll be selling and moving on to another stock. You might hold the stock for a short time or a long time—it depends on the price movements and your plan of action. You have no real interest in the company that issued the stock other than it is in the right place at the right time.
Investing in a Company
When you invest in a company, however, it's because 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. Plus, you understand what the company does and its sustainable competitive position in its market.
When you buy a share as investor, rather than a speculator, you plan to hang on to your holding for a long time.
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. Then you can act accordingly.
When Stock Prices Fall
As long as the stock’s price is performing well, both the speculator and the investor are satisfied.
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. If you're speculating, you have no emotional attachment to the stock, so getting rid of the loser at a predetermined point is easy.
Some 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.
Sometimes, you've started out speculating but decide you like the stock despite the poor performance, and decide to hold it instead of cutting your losses. The speculator has become an investor.
Where Speculators Go Wrong
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?
At the same time, 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 of potential returns.
Rules for Speculating in Stocks
To prevent yourself from abruptly switching from speculator to investor and possibly missing out on returns, it's important to have a plan.
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 (when a sale happens regardless of the size of the gain or loss)
- Stick to these rules
- Keep a journal to analyze how well the trading rules work
The exit points for your trade 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, and so on. 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.
Rules for Investing in Companies
The system is not that much different for investors. Aside from having criteria to find companies to buy, as an investor you should:
- Decide on what events would change your opinion of the firm (i.e., decide the investment is a mistake)
- Decide on what price would make it irresistible to sell because of overvaluation
- Analyze when positions should be added to or reduced from the portfolio
- Stick to these rules
- Keep a journal to analyze how well the investing rules work
The main difference in the rules for investing compared to the rules for speculating is that speculators consider time limits to their trades.
The sale criteria can vary based on price to earnings (P/E), price/book, enterprise value/earnings before interest, taxes, depreciation, and amortization (EBITDA), or other fundamental valuation ratios. Or, it can be relative to the other opportunities you see. For example, to sell in order 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.