Lesson 6 of 7
Investing or speculating?
Graham's test for an investment is analysis, safety of principal and an adequate return. Short of that is speculation.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Graham's test is not about what you buy. It asks whether the purchase rests on analysis showing safety of principal and an adequate return.
- Anything short of that is speculation, whatever the asset and however long you hold it.
- The same share, bought on the same day, can sit on either side of that line depending on why it was bought.
Graham's test for telling an investment from a speculation asks how a purchase was made, not what was purchased. An operation resting on analysis that shows safety of principal and an adequate return is an investment. Everything else is speculation, including a share held for ten years that was bought only because its price was rising.
Process against outcome
RowsWas the analysis done firstColumnsDid it make money
Yes, No
Investment that lost money
Yes, Yes
Investment that worked
No, No
Speculation that lost
No, Yes
Speculation that paid off
The test is about the process
Graham's chapter 1 definition names no asset class and no holding period. It asks three things of a purchase: that it rest on thorough analysis, that the analysis show safety of the principal paid, and that it promise an adequate return. A purchase clearing all three is an investment. A purchase resting on a story, a tip or a price that has been climbing clears none of them, whatever it is called and however sophisticated the reasoning sounds afterward.
The definition is narrow. It does not ask whether the purchase turned out well, because a speculation can still pay off and an investment by this test can still lose money. It asks only whether the work was done before the money moved.
The same share, two ways
Bought as an investment
- Rests on analysis of the business and its filings.
- Aims to show safety of the principal paid.
- Aims at an adequate return.
Bought as speculation
- Rests on a price move, a tip or a story.
- Principal is at risk beyond what any analysis bounded.
- The return is whatever the price happens to do.
Graham's line runs through the reasoning behind a purchase, not through the asset itself.
Temperament decides which one you do
A written estimate is easiest to keep before the price moves and hardest to keep once it does. The same pull that makes Mr Market's mood tempting is what erodes a written estimate into an afterthought, dropped because the quote is rising and the story now writes itself to fit it. Keeping the estimate in writing, made before the price moved, is what keeps a purchase on the investment side of Graham's line, because it gives you something fixed to check the rising price against instead of only the price itself.
This is why the same test applied to the same share can come out differently for two people, and even for the same person twice. The analysis is what Graham asks for. The temperament to stay with it once a quote starts moving is the harder part.
Speculation is not illegal or immoral. The danger is doing it while telling yourself you are investing.
Check yourself
By Graham's chapter 1 test, what turns a purchase into an investment?
- Buying a share rather than a bond
- Analysis showing safety of principal and an adequate return
- Holding the position for more than a year
Show the answer
Answer: B.
The test is about the reasoning behind the purchase. Neither the asset class nor the holding period decides it.Two people buy the same share on the same day. Can one be investing and the other speculating?
- No, the asset decides which one it is
- Yes, the test is about the reasoning behind the purchase
- Only if they paid different prices
Show the answer
Answer: B.
Graham's line runs through the process, not the asset. The same share bought the same day can sit on either side of it.What tends to erode a written estimate of value once the price starts moving?
- A change in the accounting standard the company follows
- Temperament, the same pull Mr Market's mood creates
- A stock split
Show the answer
Answer: B.
The estimate is easiest to hold before the price moves. Once it moves, the pull to abandon it is temperament, not new analysis.Sources
- Graham, The Intelligent Investor, revised edition 1973, chapter 1, on the line between investment and speculation.
- Graham, The Intelligent Investor, revised edition 1973, chapter 8, on Mr Market and the temperament an investor needs toward his price.
- Berkshire Hathaway shareholder letter, 2000, on speculation as a focus on what the next buyer will pay rather than on what the asset produces.
What this leaves out
- The two purchases and their prices are invented and illustrative. They name no real company.
- Graham's test is about process, not outcome. A purchase that passes it can still lose money, and one that fails it can still make one.
- Nothing here is advice about any security.