INVESTMENT ANALYSIS - TREATED QUESTIONS

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QUESTION:

Distinguish Carefully Between Investing and Speculating. 

ANSWER:

It is well nigh impossible to define the term ‘speculation’ with any precision. Investment and speculation are somewhat different and yet similar because speculation requires an investment and investments are at least somewhat speculative.

Investment usually involves putting money into an asset which is not necessarily marketable in the short run in order to enjoy a series of returns the investment is expected to yield. On the other hand, speculation is usually a more short-run phenomenon.

Speculators tend to buy assets with the expectation that a profit can be earned from a subsequent price change and sale. Accordingly, they buy marketable assets which they do not plan to own for very long.

Probably the best way to make a distinction between investment and speculation is by considering the role of expectations. Investments are usually made with the expectation that a certain stream of income or a certain price which has existed will not change in the future. Speculations, on the other hand, are usually based on the expectation that some change will occur. An expected change is a basis for speculation but not for an investment.

Speculation involves a higher level of risk and a more uncertain expectation of returns but in many cases the investors are also in the same boat. The investor who thinks that the market fluctuations of his investments are not of interest to him because he is buying solely for income can very well be compared with the ostrich burying its head in the ground during danger and feeling himself secure.

The trained speculator takes action only when the probabilities are higher in his favour. Though the speculator should not swing with each fresh current but this does not imply inflexible behaviour on his part. When the evidence builds up unmistakably against his view, he must be able to change it without becoming disorganized. His notions of prestige must not attach irrationality to his opinions.

For the speculator, pride of opinion is the costliest luxury. In fact, the speculator must have the courage to make decisions when the general atmosphere is one of panic, despair, or great optimism and yet go against the current. The crowds is wildly bullish at tops and in a panic at bottom, and these emotions are highly contagious.

The truth of the matter is that everything we do in this world is a speculation, whether we regard it as such or not, and the man who comes out in the open and uses his judgment to forecast the probable course of events, and then acts on it, is the one who would reap the returns of his endeavour.

This is a peculiar psychology that makes many investors avoid certain sound stocks or bonds because their broker speaks of “speculative possibilities”. These investors judge safety by yield. If a security pays beyond certain percentage it is classed as “speculative”, and is not for them.

What is the solution of the problem of investing primarily for income and yet relating the very important and useful quality of ready marketability without loss? It is best solved by never making an investment that does not appear after investigation, to be an equally good speculation.

It follows that speculative investment may be undertaken with the expectation of success only by those specialists who are able, out of their knowledge and experience, to weigh carefully the possible outcomes.

Furthermore, because of the great risk, what is expected by the speculator is not that he will not make errors of judgment, but that his substantial resources and superior judgment will permit him on balance to expect to maximize aggregate gains.

Another point often raised is, “can the man of limited mean afford to speculate?” The reply to that question depends on what is inferred by the word ‘speculate’. If one means to buy rapidly fluctuating stocks on margin in the hope of getting aboard the right one, the answer is emphatically “No”! But if one’s idea of speculation is the right one that is, to buy sound stocks for cash after a careful study of factors apt to affect their future prices, it is certainly good policy. Indeed, no man ever becomes wealthy without speculating in something.

There is no such thing as something for nothing. Those who come to the stock market with visions of easy money are apt to leave it sadder, if not wiser. We get out of things what we put into them, and brains and money used in an honest effort to secure reasonable income on profits in the stock market generally receive a just reward.

In a sense, all purchase and ownership of securities are speculative. However, there are important differences between speculation and investment. Here we will contrast the behavior characteristics between an investor a speculator.

  QUESTION:

Compare Briefly the Traditional and modern approaches to security analysis;

ANSWER:

Traditional investment analysis, when applied to securities, emphasizes the projection of prices and dividends. That is, the potential price of a firm’s common stock and the future dividend stream are forecasted, then discounted back to the present. This intrinsic value is then compared with the security’s current market price. If the current market price is below the intrinsic value, a purchase is recommended, and if vice versa is the case sale is recommended. Although modern security analysis is deeply rooted in the fundamental concepts just outlined, the emphasis has shifted. The more modern approach to common stock analysis emphasizes return and risk estimates rather than mere price and dividend estimates.