Over the course of the past several decades, the term "investor" has evolved into including anyone who owns a share of stock. When a person purchases stock, they are doing it as one of two people: either an investor or a speculator.
What's the difference? An investor is someone who carefully analyzes a company, decides exactly what it is worth, and will not buy the stock unless it is trading at a substantial discount to its intrinsic value. Investors are able to distinguish between investment fads and investment value.
Investors determine a share's worth, decide if it is under or overvalued, and purchase if it is undervalued. They make their investment decisions based on factual data and do not allow their emotions to get involved. A speculator is a person who buys a stock for any other reason.
- Investors make their investment decisions based on factual data and do not allow their emotions to get involved.
- Speculators buy stock on the chance that it might rise from any cause other than a recognition of its underlying fundamentals.
- The speculator will drive prices to extremes, while the investor evens out the market.
- Investors believe that, though the stock market might depart from the fundamentals of a business in the short-term, in the long run, the fundamentals are all that matter.
Why Speculators Buy Stock
Often, speculators purchase shares in a company because they are "in play," which is another way of saying a stock is experiencing higher-than-normal volume and its shares have the appearance of being accumulated or sold by institutions. They buy stock not on the basis of careful analysis, but on the chance that it might rise from any cause other than a recognition of its underlying fundamentals.
Speculators look for and follow trends, while investors hunt for value.
Speculation itself is not necessarily a vice, but its participants must be absolutely willing to accept the fact that they are risking their principal. While it can be profitable in the short term, especially during bull markets, it very rarely provides a lifetime of sustainable income or returns. It should be left only to those who can afford to lose everything they are putting up for stake.
How Does Investment and Speculation Affect Stock Price?
The speculator will drive prices to extremes, while the investor evens out the market (generally selling when the speculator buys and buying when the speculator sells)—over the long run, stock prices end up reflecting the underlying value of the companies.
If everyone who bought common stocks were an investor, the market as a whole would behave far more rationally than it does. Stocks would be bought and sold based on the value of the business. Wild price fluctuations would occur far less frequently because as soon as a company appeared to be undervalued, investors would buy it, driving the price up to more reasonable levels.
When a company became overpriced, it would promptly be sold. Speculators, on the other hand, are the ones who help create the volatility the value investor loves. Since they buy securities based sometimes on little more than a whim, they are apt to sell for the same reason.
This leads to stocks becoming dramatically overvalued when everyone is interested and unjustifiably undervalued when they fall out of vogue. This manic-depressive behavior creates the opportunity for us to pick up companies that are selling for far less than they are worth.
Fundamentals Matter to Investors
A fundamental belief among value investors is although the stock market might wildly depart from the fundamentals of a business in the short-term, in the long-run the fundamentals are all that matter. This is the basis behind something the father of value investing, Ben Graham once wrote:
"In the short-term, the market is a voting machine, in the long-term, a weighing one."
Have you ever heard anyone say that the economic fundamentals of a company have no relation to the stock price? This is completely false. A simple response should be all that is required. Ask them "If fundamentals don't matter, what if Coca-Cola never sold another bottle of Coke? How long do you think the stock price would stay at its current level?"
Fundamentals do matter. They matter because if corporations issue stocks and do not follow these fundamentals, bubbles are created. Bubbles have a tendency to burst and leave speculators devastated when they do.
Fundamentals Are Not a Myth
Unfortunately, countless investors believe this myth. The perfect example of this is the dot-com boom of the late 1990s. Companies that generated no profit and had little book value were selling at astronomical levels. "Surely this would prove that fundamentals mean nothing," some would argue.
On the contrary, it proves the point entirely. Only a few short years after the initial stock market bonanza, the economic realities of these companies came back to haunt them. Most fell 90% or more from their highs, with many more going bankrupt, ultimately worth less than the paper their stock certificates were printed on.