Investing vs Speculating and Volatility

Let’s start with that word ‘volatility’, for the average investor it is a word to be feared but we need to understand that it is here to stay.

 ‘Volatility is the rate at which the price of a security (share) increases or decreases for a given set of returns. Volatility is measured by calculating the standard deviation of the annualized returns over a given period of time.’ If the prices of a security fluctuate rapidly in a short time span, it is termed to have high volatility. If the prices of a security fluctuate slowly in a longer time span, it is termed to have low volatility.

Are you any the wiser? We so lightly throw these words into advice given to our clients, on the receiving end, you the client, are not really sure how you should apply this in your own situation. 

In fact, movement of share prices in the market, on any trading day is a given and, an everyday fact of life for the investor. Market movement can be caused by so many factors, for example; domestic or global events; such as War, Natural Disasters, changes in Government, budget announcements or the biggest factor is investor reaction to news about a specific company. Alternatively, it can be just a case of supply and demand for a particular share, if more investors want to BUY a particular share than want to SELL it, this pushes the share price up.

There have been times during the past 12 months when investors were concerned about volatility and have wanted to ‘sell out’; if they had done so, they would have lost some of the overall return or total return on their share investments.

With the rise in values, if they wish to ‘get back into’ shares they may be paying a higher price; also, if they had sold at that ‘low point’, they would also have missed out on subsequent dividends.

Now is a good time to reflect on the difference between speculating in shares and investing in companies.

Benjamin Graham wrote in 1949[1]An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return - Operations not meeting these requirements are speculative. While we may use different words today, the definition remains.

Let’s look at what Peter Thornhill’s book (Motivated Money)[2] has to say about this: He quotes the dictionary definition “To INVEST is to put money into a business (company) with a clear purpose of making a profit, when we INVEST, we expect that our investment will provide us with income or profit” “When we SPECULATE, we buy or sell commodities, stocks (shares) or land in the HOPE that there will be an unexpected rise in the price”

To buy an asset because the price looks low and then expect to sell when the price is high in the belief we can ‘time’ the market is to SPECULATE and this is risky.

We choose to INVEST in a company because the product they make or the service they offer is sound and they have a strong customer base. We understand what the company does, what their debt level is, whether they have sound strategies for growth and are competing strongly in their field against other like companies. We look at the company’s return on investment and whether their income to the investor is franked. Then we decide we would like to own part of that company. That is INVESTING.

However, I should note that risk is still inherent in investing in any company as there is always the possibility that the company will generate a profit or a loss in any given reporting period. We then look at the reason why, and make a decision about whether to continue to hold the stock or to sell, but not based on share price.

I know there is a great deal more financial data to be taken into account than I have set out here. I want to point out that there is a difference between investing and speculating and note that when constructing a portfolio, it goes deeper than suggesting that a particular share ‘looks cheap’ at the moment. If you want to invest in a company and you are not sure how the company operates, what businesses they are invested in, or how they have performed financially, you should ask your Adviser. 

Your decision should not solely be based on today’s share price; just remember if share prices are high it makes the investor feel that there is little risk in the market when in fact, it is when the market is highly priced that there is the greatest risk of losing value.