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Investment, Speculation, and Gambling

In addition to whatever you own, you have been given $20,000. You are now asked to choose between:
  • A sure loss of $5,000
  • A 50% chance to lose $10,000 and a 50% chance to lose nothing.

     What exactly are the definitions of the terms "investment" and "speculation" and how can investors differentiate the two? Despite the diligent efforts of some of Wall Street's greatest minds, there are no universally accepted definitions. Yet, the investment industry has evolved in many ways since many of the classic definitions were originally suggested and we have securities and tools available that investors can use to disentangle investment from speculative and hedging activities.

     Some securities are referred to as speculative despite the fact that logically, they can be viewed as investments. Adding to the confusion is the fact that in both the short and long run, investors sometimes lose money while speculators sometimes make money. There are many other scenarios that present interesting questions. Is an investor that buys a government bond in search of a short term gain (for instance from dropping interest rates) investing or speculating? U.S Government bonds (Treasury Bills, Bonds and Notes) are considered "risk-free" and certainly are not considered speculative securities by most. Yet these securities are used frequently to speculate on the direction of interest rates.

     The majority of individual venture capital investments result in losses. However, venture funds often yield higher returns than stocks because one or more of the funds' investments yield many times the initial investment (thus more than making up for complete losses of other venture capital investments).

     Legendary investor Benjamin Graham considered the distinction between the two activities so important that "Investment versus Speculation" is the title and subject of the first chapter of his classic book The Intellient Investor. According to Graham, "The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. We have often said that Wall Street as an institution would be well advised to reinstate this distinction and to emphasize it in all dealings with the public. Otherwise the stock exchanges may some day be blamed for heavy speculative losses, which those who suffered them had not been properly warned against."

     In 1934, Graham and David Dodd addressed the issue and offered a definition of "investment" in their classic book Security Analysis.

"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

     Another often cited definition was offered by John Maynard Keynes in The General Theory of Employment, Interest, and Money.

Speculation: The activity of forecasting the psychology of the market.
Speculative motive: The object of securing profit from knowing better than the market what the future will bring forth.

     Bond rating agencies commonly use the term "speculative" when rating bonds, which raises the question of whether buying a high yield (also known as “junk”) bond is speculation or investing? The answer, of course, depends on your definition of the terms, and in this case it’s important to examine exactly what the ratings represent. Bonds rated lower than BBB by Standard & Poor’s (S&P) (or Baa by Moody's) are frequently associated with the term "speculative." With S&P, the term "speculative" refers specifically to the entities "capacity to pay interest and repay principal in accordance with the terms of the obligation." The rating is not meant to imply anything about the bond's price and makes no recommendation regarding its value and whether an investor should buy or sell the security at any given price.

     The use of junk bonds increased dramatically in the 1980s and Michael Milken initially became famous by marketing the securities on an unprecedented scale (and earning hundreds of millions of dollars for himself and his firm in the process). Milken cited research by W. Braddock Hickman from 1958, but according to high-yield bond expert Martin Fridson, arguments in favor of high yield bonds can be found from as early as 1904. The rationale for high yield bonds is that their higher yields more than compensate for their added risk. Therefore a strong argument can be made that junk bonds are logical investments for investors.

     Martin Fridson is a world class historian and has authored many academic papers, as well as numerous books. He also authored one of the most thorough discussions of "speculation" in the Fall 1993 issue of the Journal of Portfolio Management. In "Exactly What Do You Mean By Speculation?" Fridson addressed numerous definitions of "speculation" and discussed some unique and intriguing aspects of the debate. Fridson's "Compendium of Definitions of Speculation" included no less than 20 interpretations from assorted text books, dictionaries, encyclopedias, and other books. Fridson divided the definitions of speculation into four categories. The definitions either implied the use of, or involved (1) price changes, (2) quick profits, (3) high risk, or (4) some combination all three elements.

     Taking the debate a step further, Fridson suggested viewing speculation in the context of "Modern Portfolio Theory." Building on the work of Harry Markowitz, William Sharpe, and others, Fridson concluded that "The common thread between speculation (as currently defined) and transactions that seem speculative, yet fail to satisfy all the established criteria, is that they are all bets against the consensus view." In offering a new definition of speculation, Fridson proposed the term "subdiversification" to describe all deviations from the market portfolio. A portfolio can consist of all asset classes or a single specific asset class. Having introduced the new term, Fridson then offered his definition of speculation.1

Subdiversification: Ownership of a mix of assets other than a fully diversified, market-weighted portfolio.
Speculation: Subdiversification with the intention of earning a superior risk-adjusted return.

     Fridson was quick to point out that definitions can be dangerous and made two points in attempting to prevent misunderstandings. "First, there is no inherent contradiction in acknowledging that a deviation from the market portfolio in pursuit of capital gains is, by definition, speculation, while rejecting the claim that securities markets are perfectly efficient ... At any given time, however, judging which securities are misvalued involves a certain amount of conjecture. 'Speculation' is therefore a fair term for attempts to exploit pricing anomalies. Again, it should be regarded as a description, rather than a pejorative appellation. Second, a genuinely usable definition of speculation must take into account that many portfolio managers concentrate within subsets of the universe of assets."

     Fridson noted in 2013 that to his “knowledge, no one has challenged my conclusions in the intervening decades“ and I am unaware of any challenges since then.2

Speculation - "the assumption of considerable business risk in obtaining commensurate gain."
Commensurate Gain - "a positive expected profit beyond the risk-free alternative. This is the risk premium."
Considerable Risk - "the risk is sufficient to affect the decision."
Gamble - "to bet or wager on an uncertain outcome."
Investments (1998) by Zvi Bodie, Alex Kane, and Alan Marcus

     In their textbook titled “Investments” Bodie, Kane, and Marcus argued that the primary difference between speculation and gambling (as defined above) is "commensurate gain." They reason that "a gamble is the assumption of risk for no purpose but enjoyment of the risk itself, whereas speculation is undertaken in spite of the risk involved because one perceives a favorable risk-return trade-off. To turn a gamble into a speculative prospect requires an adequate risk premium for compensation to risk-averse investors for the risks that they bear. Hence risk aversion and speculation are not inconsistent."

It's like a crapshoot in Las Vegas, except in Las Vegas the odds are with the house. As for the market, the odds are with you, because on average over the long run, the market has paid off.
Harry Markowitz3
Harry Markowitz certainly wasn't the first to compare the stock market to gambling. Analogies and metaphors comparing investments with casino games and other games of chance are commonly used on Wall Street. Humans of course, have a long history of engaging in and developing addictions for gambling. According to Peter Bernstein, the earliest form of gambling may date back to 3500 BC when a kind of dice game called astragali was played. In Against the Gods, Bernstein discussed gambling in the context of risk. Bernstein traced the history of numbers, probability theory, and the development of people's perception about risk and gambling. According to Bernstein, "Human beings have always been infatuated with gambling because it puts us head-to-head against the fates, with no holds barred. We enter this daunting battle because we are convinced that we have a powerful ally: Lady Luck will interpose herself between us and the fates (or the odds) to bring victory to our side."

     Given how prevalent casinos, lotteries, and sports betting have become it's easy to understand why people might confuse speculation and gambling with investment.

Lottery games date at least to biblical days … Christ's robe was given to a lottery winner so it would not have to be cut. The Sistine chapel and its paintings were supported by lotteries. The Italian lottery has been running continuously since 1530. Lotteries are played in over 100 countries.
Richard Thaler in The Winner’s Curse

     Our experiences with lotteries can shed additional light on people's obsession with risk. Millions of people are willing to stand in lines to buy a one dollar lottery ticket with much worse than one-in-a-million odds. The odds of Powerball, which is played in over 40 states, has gotten progressively worse as the quantity of numbers has increased from 49 to 59 to 69, with a one in 292 million chance of winning the top prize (as of 2015). For every one dollar lottery ticket purchased, usually only 40 to 60 cents goes into the pot and is returned to ticket buyers. Lotteries are negative-sum games because the total payout is less than what goes into the pot. It's not surprising that some have gone so far as to describe lotteries as a "tax on stupid people." Yet, on the other hand, as Richard Thaler points out in The Winner’s Curse, "it is easy to rationalize the purchase of a lottery ticket by saying that for a dollar purchase, the customer is paying 50 cents for a fantasy. That's a pretty good deal."

     Meir Statman elaborates on comparing lotteries as a negative sum game to the trading aspect of investing.4

"Stock trading also is a negative-sum game. But whereas the frame of lottery-ticket buying as a negative-sum game is transparent, the frame of stock trading as the same game is opaque. As Treynor (1995, originally 1971)5 noted, people confuse the stock-holding game with the stock-trading game. The stock-holding game is a positive-sum game; buyers of stocks can expect to receive, on average, more than they spend. The stock-trading game, however, is a negative-sum game. In the absence of trading costs, management fees, and expenses, stock traders can expect to match the returns of an index of all stocks. But after trading costs are considered, they can expect to lag that index. Indeed, Barber and Odean (2000a)6 found that not only do stock traders, on average, lag the market but that the magnitude of the lag increases with the amount of trading."

     Statman further elaborates on the why people who are normally risk averse would play lotteries despite the (very, very slight) possibility of a high expected return. He contrasts that with the puzzle of why so many are willing to trade given the strong possibility that the opposing trader has superior information. Fischer Black (1986)7 and Jack Treynor offered two theories. Traders think that they are above average and have superior information or skill, and/or traders simply like to trade. He concluded by asking "Is it wise to extinguish dreams that sell for a dollar?"

     Reuven Brenner points out that there are some additional distinctions with gambling, particularly that people are willing to gamble for entertainment purposes rather than strictly based on the probabilities and expected returns.

“Still, recall the last five 'don’t’s' of the Ten Commandments (don't kill, don't steal, don't bear false witness, don't covet, and don't commit adultery) are sound advice for the ages, 'don't gamble' is not on the list. As it turns out, with excellent reasons."
Reuven Brenner in A World of Chance: Betting on Religion, Games, Wall Street

     Perhaps it is the fact that the stock market and other investments generally rise over the long term that draws speculators to investment markets. As Markowitz points out, stocks in general are a positive-sum game since they rise in the long term. But, while an investor purchasing a stock has a positive expected return, his or her expected return relative to the market is zero (before costs).

     This was documented by William Sharpe in 1991 in a paper titled "The Arithmetic of Active Management."8 Because investors have the option of investing in index funds, the returns from a specific market (or asset class) and any individual security can be separated. Since Sharpe's article was published, passive investing has grown significantly. Passive funds accounted for a third of mutual fund assets according to figures compiled by Morningstar in 20169 and passive funds have been attracting inflows of hundreds of billions of dollars per year recently, while actively managed funds have had outflows.

     The key argument is that any movement away from the broad benchmark index of an investment asset class is speculative. That can consist of dropping one or more securities from an index, or choosing to invest in only one security from an index (or anywhere in between). In other words, passive (index) management (in asset classes with positive historical real returns) is investing and active management is speculative relative to the passive benchmark. And while passive investing has grown dramatically in the last few decades, active investing remains the majority of trading activity.

     In “The Cost of Active Investing” (published in the Journal of Finance in August 2008) Kenneth French estimated U.S. investors spent over $100 billion (more than $330 dollars in resources for every man, woman, and child in the United States) trying to beat the stock market in 2006 (up from $7 Billion in 1980 and $30 Billion in 1993). The estimate for all United States gaming revenue for 2006 was $90.9 Billion according to the American Gaming Association. $32 billion of that was from commercial casinos, nearly as much at Indian casinos, and the rest was lotteries, race tracks and other gaming operations. So based on those estimates, more money was spent in the U.S. trying to beat the stock market than was lost at casinos, card rooms, legal bookmaking, lotteries, and horse races combined. And that doesn't include active investing in bonds and other assets.

     Of course there are many managers that have beaten their benchmarks over extended periods, Warren Buffett being a commonly cited example. Howard Marks is another individual that has also weighed in on the investing versus speculating debate (in 2013 and many other times)10 and his track record contributed to his firm (Oaktree Capital) managing over $100 billion, making it the largest distressed securities investor in the world. We have to address the issue of active managers that outperform over extended periods. I do believe there are talented managers that can win despite being speculators, but it takes a large number of observations before you can statistically estimate that a manager is skillful, as opposed to lucky (more than that in chapter ten). But even so, many that do well fail to repeat that success going forward. I certainly would not bet against Buffett or Marks, who also backed Jeffrey Gundlach (another individual that shows the signs of a skilled investor/speculator, specifically in the bond market).

     My perspective on defining investing and speculating is similar to Fridson's and others that point out that investing has to have an element of a positive expected risk-adjusted return. In other words, to qualify as investing, the specific asset class, or activity should include both 1) a theory as to why returns in aggregate and over the long term will be above inflation, as well as 2) empirical evidence proving that. Stocks and bonds (measured by broad indexes) meet that criteria, but active management does not because we know both from theory and empirical evidence that active managers do not add value relative to their benchmarks.

     Following up on Fridson's argument, my primary point is that the debate often misses the major development of the last 40 years that has changed the investment versus speculation debate. That major development is the introduction and evolution of passive index funds. Buying one stock is a combination of investing in the stock market and a bet on the specific company. Buying a stock index fund separates the buying stocks (asset allocation), from individual stock picking. And therein lies the distinction between an investment and a speculation. The investment is buying stocks, which historically have returned about 6.5% more than inflation in the United States and roughly 5% more than inflation worldwide (more on historical returns and data sources later). Betting on one stock is part investment, and part speculation relative to the stock market.

     A good follow-up question is whether those that attempt to take advantage of anomalies or "risk factors" are investing or speculating. For instance, if we have both theory and empirical evidence that value stocks and/or small cap stocks have outperformed (which are discussed in more depth in later chapters), then buying value and/or small caps is not speculative by a definition that includes theory and evidence of a positive risk adjusted return. Fridson's raw definition of subdiversification from the market portfolio may define a value or small cap tilt as speculative, yet perhaps a further definition of speculation needs to identify speculation as either prudent/imprudent, or intelligent/unintelligent (with a value or small cap tilt perhaps qualifying as prudent speculation). Additionally, there are other reasonable arguments for deviating from a market portfolio (for instance, if a capitalization weighted index has one or more components that make up a large percentage of the index, some would prefer to reduce that exposure).

     Another fair question is whether high frequency traders are investors or speculators. Some define investing as long-term, but I do not. I would consider a true arbitrageur to fall under the investor category. Arbitrage is buying something in one location and selling it (or its equivalent) in another for more (thus profiting by the difference). Similarly, I consider market-making high frequency traders to be investors as well. Both in theory (you can make money as a middle man between those that buy and sell securities) and in practice, market makers are generally profitable over time. However, high frequency traders attempting to profit from momentum or trading ahead of presumed large investors is less clear cut.

     The question at the start of the chapter is a slightly modified version (by a factor of 10) of the question asked by Daniel Kahneman and Amos Tversky in their seminal paper published in 1979.11 69% chose B, indicating in that scenario that those surveyed would prefer to take the riskier option (more on the implications of that in a later chapter).

“People who invest make money for themselves; people who speculate make money for their brokers.”
Benjamin Graham, The Intellient Investor

Notes - The Footnotes in the Book are sequential and for this chapter start at #87 and end at #97.

1. Martin Fridson, "Exactly What Do You Mean By Speculation?" Journal of Portfolio Management, Fall 1993
2. Investing vs. Speculation (3/1/2013)
3. Harry Markowitz, "Risk Management: Improving your Odds In the Crapshoot," Bloomberg Personal (July 1996)
4. Meir Statman "Lottery Players/Stock Traders" Financial Analysts Journal , Jan/Feb 2002
5. Jack Treynor, The Only Game in Town, Financial Analysts Journal, March/April 1971 and January/February 1995
6. Brad Barber, Terrance Odean, Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment, Quarterly Journal of Economics, April 2000
7. Fischer Black, Noise, Journal of Finance, July 1996
8. William Sharpe, The Arithmetic of Active Management, The Financial Analysts' Journal, January/February 1991
9. (9/11/2016)
11. Daniel Kahneman and Amos Tversky, Prospect Theory: An Analysis of Decision Making Under Risk, Econometrica, 1979

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Table of Contents and Launch Site

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