Are We Investing or Speculating in Growth Stocks?

By Kevin M

How is it, that when we put money into commodities or raw land, we?re ?speculating?, but when we buy growth stocks or growth stock mutual funds, we?re ?investing?? Where?s the dividing line? Is there a dividing line, or is it all marketing spin?

In recent decades, investing in the stock market has become common even and especially among the middle class. We?re routinely guided to ?invest? money in stocks for future gain, and inundated with newspaper, magazine, TV and internet ads promising us double digit returns for placing money in this or that mutual fund?albeit with the caveat ?past performance is no guarantee of future performance?. But exactly how do we process all of that? Do we process it at all?

In Investing Basics: What Is an Investment? Paul Williams at Provident Planning introduces the concept of familiarity blindness, a state in which ?most of the basic questions don?t occur to (us) any more?. This is a valid observation of the human tendancy to avoid challenging assumptions once they?re fixed in our minds. Though we give lip service to the volatility of the stock market, do we also turn a blind eye to it’s clear speculative nature?

What is investing, and what is speculating?

Paul describes speculating as, ??often a zero-sum game, where someone else has to lose so you can win (and where) No wealth is created?it simply changes hands.? I?m on board with that.

Dictionary.com defines the two terms as follows:

Investing: to put (money) to use, by purchase or expenditure, in something offering potential profitable returns, as interest, income, or appreciation in value.

Speculating: to engage in any business transaction involving considerable risk or the chance of large gains, esp. to buy and sell commodities, stocks, etc., in the expectation of a quick or very large profit.

The definition of speculating seems clear, but the description of investing is broad enough to be close to meaningless–I think what it describes is the popular connotation of investing more than anything else. Note the last part of that definition, “or appreciation in value”; isn’t that the very reason one would buy commodities or raw land? Why is that not considered investing as well?

The argument that commodities and land are speculations is typically based on the claim that they pay no interest or dividends. I fully agree. But wouldn’t growth stocks fall under the same category? Most pay no dividends, or even offer a promise of doing so in the foreseeable future, yet when we put money into them, we somehow believe we?re investing.

Let?s take one more shot at definitions. I was a finance major in college, and in a course called ?investment theory and analysis? I had a professor (who actively worked on Wall Street) who said that you?re investing when you buy an asset that gives you a revenue stream (interest or dividends); you?re speculating is when you buy an asset with no revenue stream in the hope that it will be worth more in the future. This is also known as the greater fool theory–buying an asset at a certain level in the hope of finding a greater fool who will come along and pay a still higher price.

The only reason anyone sinks money into non-dividend paying stocks is the ***hope*** that they will either a) pay dividends in the forseable future or, much more likely, b) rise substanitally in value. How is that different than what one might hope to do in buying commodities or raw land?

From a practical standpoint, I think my professor offered a bankable distinction. Put this way, should we be looking at growth stocks in a different way?

Two stock market crashes in 10 years should have us thinking

The purpose of this post isn’t to advocate for commodities and raw land being similarly classed as investments in the way we label growth stocks, but to emphasize that all asset classes that offer no immediate revenue streams are speculations by their very nature. Marketing spin aside, they should be called what they really are and handled accordingly.

Would you put money into growth stocks if a financial advisor (or marketing pitch) recommended that you put your money to work “speculating in growth stocks”? No, put that way, it just doesn’t sound quite as appealing, as certain, or even as responsible as if you were told to put your money to work ?investing in growth stocks?. One word changes everything.

If putting money into growth stocks is in fact speculating, how should that change our behavior?

  • Make sure that most of your money is properly invested in income producing assets like CDs, Treasuries, bonds and dividend paying stocks.

  • Have only a minority percentage in growth stocks (speculations). View them in the same way you would commodities. A famous investor (but not famous enough for me to remember his name) recommended ?investing down to the sleeping level?. Sound advice!

  • Tune out the investment chatter from the media. Besting market averages requires outperforming the market consistently over decades and extremely few ever master that.

  • Structure your investments to be relatively worry-free. Unless you?re independently wealthy, keep your mind free and your time clear to concentrate on your occupation where the real money will be made.

  • Paying off debt is a true investment. Not only does it offer a guaranteed return from the interest not paid, but it also improves your cash flow and opens up options in life that you can?t have as a debt serf. This needs to be a priority.

  • Adjust your retirement savings projections to fit reality. In Will A Million Dollars be Enough to Retire On? we covered the absurdity of perfect world retirement portfolio projections. Workable retirement planning should incorporate a combination of good health, a debt free position, the ability to live beneath your means, and work you can do for the rest of your life.

I believe most people should have at least some of their money in growth stocks. The potential payoff is real, but just as real is the risk that?s being taken on in the process. Make sure you understand that risk fully, and have taken steps to minimize it?s impact first.

Based on the way you have your ?investments? configured, are you investing, or are you speculating?
 

13 Responses to Are We Investing or Speculating in Growth Stocks?

  1. Great points Kevin. This affirms my premise that a lot of investors are probably too aggressive for their goals and their own risk tolerance.

    Most people want to be aggressive when in a bull market, but quickly change their tune once the markets shift. It’s this kind of fickle investing that actually leads to poor long-term returns.

    Understanding the nature of the beast goes a long way in helping even out returns and achieving goals.

  2. Jason – Yeah, the key is taking the long view, which means recognizing and (more important) preparing for the non-perfect world scenario. Our culture is so inherently optimistic that contrarian voices are often ignored until it’s too late.

    It’s probably best to begin any endeavor with the question, “what could go wrong here?”. With growth stocks I think there tends to be an assumption that I’ll make my killing and get out before the crap hits the fan. Few people can beat the market consistenly, and none can predict the future. We need to have a healthy respect for that.

  3. You bring up some great points, Kevin, and I completely agree that too many investors expect far too much and probably take more risk than they should without a proper understanding of investing.

    But there’s a major difference between investing and speculating that you’ve missed in your article, and it’s the main reason why we look at growth stocks as an investment but commodities/land as speculating.

    When you’re investing in growth stocks, you’re not investing with the hope that just the stock itself is going to magically increase in value because someone else wants it more (for some unknown reason or because they’re a sucker). You’re investing because you believe the people running and working in the company represented by that stock are going to do things that add value to the company’s worth. They’re going to increase sales, reduce costs, open new markets, start new products, improve products, etc. These things add value and make the company worth more (in addition to a host of other possibilities).

    When you’re investing in commodities or real estate, your only hope (unless you or someone else is somehow improving the commodity, if that’s possible, or real estate) is that there is more demand in the future for that commodity or land. That’s the only way those investments can increase in value (besides land development). That’s why those asset classes are typically defined as speculating. (But I’m not sure they truly are because it’s unlikely they’ll lose all value for no reason at all – there’s inherent value in them by their very nature.) For commodities, I’d say futures contracts are where the real speculation happens because you can put so much at risk with very little up-front. (kind of like trading on margin)

    But the point you’ve made, which is very valid, is that most people approach investing in growth stocks with speculation in mind. They expect to make a quick and easy buck, and they might as well be gambling. That’s why it’s important to understand why you’re investing and what you’re investing in. Without a grounded logic, you’ll be easily swayed by your emotions and make the mistakes that Jason pointed out above.

  4. Paul, thanks for bringing out that distinction. I think that, technically speaking, you’re correct that the companies behind the stocks are legitimate entities, hiring workers and building a better mousetrap, so to speak.

    Your last paragraph suggests the reason why I thought this topic is worthy of discussion, which is the mindset around growth stocks. Speculation drives all bubbles to extreme heights before bursting. A bit more caution on the way up might keep us from getting trampled by the rush to the exits on the way down.

    When investing–in the true sense–we need to think strategically, which is to say we need to be prepared for different markets. With a dividend paying stock, we might ride out a downturn because we have revenue coming in. If the reason we buy growth stocks is to sell at a higher price, we’ll either bail on the way down, or hold til the bottom when price recovery might become remote. If that’s the case, we don’t want to be too heavily exposed.

  5. Well, it’s important to remember that a stock is a stake in a company. A good company is generating profits and has cashflow, irrespective of whether it pays some of that cashflow out as a dividend. If it uses its profits to buy more factories / offices / oil fields / whatever, then the value of the company and hence the shares *is* increasing.

    In contrast, if you buy a barrel of oil it produces no oil, internally or externally. It’s just a barrel of oil! 🙂

  6. Monevator – that’s consistent with what Paul Williams said above, and I agree on that point. However when the majority of a person’s money is sitting in non-income producing assets, I think they’re mostly speculating despite the economic actions of the companies behind the stocks.

    I believe everyone should have a minority position in growth stocks, even retirees, as a way to protect against inflation. But I’m not at all sure most people understand the risk they’re taking on when the majority of their money is committed in that category. In recent years, that’s been the case with many people.

  7. Great discussion! Something we like to consider when investing is the overall level of society’s values (fundamentals). If those values are on the decline, we prefer to avoid “paper promises” of any kind, to include stocks, and lean more toward tangibles…those appreciating assets you can see, feel, and taste. If society’s core values are on the upswing, however, we would be inclined to reallocate our investments toward stocks and paper promises. Many of the more famous business scandals and financial catastrophes have taken place at a time when the “good times” were rolling and no one was minding the store. In this particular day and age of Enron style accounting practices, return OF principal is probably a more important consideration than return ON principal. When we see a fundamental shift in the other direction we will begin reallocating in that direction.

  8. Steven and Debra, I think you’re on to something with that, and much deeper than you know. The moral level of the culture is also a barometer of the level of trust we should presume to exist. If trust is weak due to the moral downswing, predictability becomes suspect. The waters may be too turbulent to warrant wading in.

  9. Sorry for the double post. The first one didn’t seem to take so we attempted to replicate it. You can delete whichever one you wish without hurting our feelings.

  10. Steven and Debra – I appologize for the posting issues. I have an anti-spam widget that often quarantines legitimate comments. As much as that’s inconvenient, I prefer it to not having anti spam. You can’t believe the crap that gets posted and the amount of it.

    I saw the two comments, and took the more detailed of the two. They were both good BTW.

  11. Speculating is akin to gambling. But investing is instead, more akin to a deliberate, long term goal through the years. The former is usually done out of an indy ploy, or an estimate. The latter is done with more deliberate strategies. Perhaps that could clear up that grey area. Which does seem grey at first sight, no?

    As an ‘investor’ (Or as we dragons like to call it, hoarding) I don’t like to speculate. Whether I park my money in commodities, stocks, or bonds, I have two mindstates to abide by. 1) To hold onto it as long as possible (Do I see myself holding it for the next 10 years?) And 2) Have an exit plan, or a hedge.

    As for growth stocks.. I prefer my growth in dividends rather than. Since you can estimate mathematically, what it would grow to. But when it comes to common, capital-only stocks, it’s definitely gambling. However, with the advent of options, a real sophisticated speculator won’t pray the market goes up. And they can even turn a non-performing common stock into cash flow. It’s very complex, but options even offer defensive strategies as much as speculation.

    Personally, I would stick to my dividends though. For I’m no speculator. I would advise to speculate a tiny portfolio percentage for that home run, but I could never, ever give up that investment foundation. <3

  12. I think that the confusion stems from the fact that stocks represent two entirely different things. Stock prices are in part comprised of the income streams from the underlying businsses. That’s real. Buying that is investing. And stock prices are in part comprised of the Funny Money that is created when emotional investors bid prices up beyond fair value. That’s cotton-candy nothingness that will be blown away in time.

    There is no one good answer to the question “Is buying stocks investing or speculating?” because it can be either or both depending on the time at which you buy stocks. It’s the valuation level that applies at a given time that answers the question for you.

    Apple is a growth stock. But you cannot say categorically that investing in Apple is gambling. What if the price goes low enough that the stock is priced below fair value? Then you’re investing in something with great growth potential. It doesn’t get much better than that. But of course there are other times (more frequent) when the price of Apple is so high that putting money into it is pure speculation. It just depends.

    Rob

  13. Rob – I agree with what you say across the board. In regard to buying stocks as an income stream, that’s the “old fashioned” way, and the method still employed by most millionaires. You won’t see them loading up their portfolios with “growth stocks”. The middle class for the most part does just the opposite and put themselves purely at the mercy of stock cycles.

    I think growth stocks can be good buys if they’re out of favor, such as when their market value falls below certain measures, like net asset value or metrics based on revenue, or when an entire industry tanks in concert with the troubles of one competitor. But to put 80-100% of your portfolio into growth stocks is bald-faced speculation, and unfortunately, that’s also what a lot of people do.

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