Long Term Investing vs Speculation

Posted on 19. Feb, 2011 by TheFreeInvestor in General, Investing Philosophy

A lot of people when they think about investing in stocks, they imagine trading stocks. So, let’s try to get the basics cleared up about what I mean when I say “investing” on this site.

At a very basic level, there are two distinct ways to profit from the stock market – 1) exploit the short term pricing inefficiencies in the market, 2) share a piece of the future profits of a business by buying shares of the company when they are temporarily mis-priced in the market and holding the shares for a long time.

The day traders, technical/chart based traders, high frequency traders, options strategy artists and arbitrageurs etc fall into the first category. They try to take advantage of some apparent short term (which can be a fraction of a second in case of high frequency traders) mis-pricing of securities in the stock market. They are taking advantage of the friction in the market. There are many differing opinions about the effectiveness of various methods used by these market players. From a market functioning perspective, these short term players improve efficiency of the market by creating liquidity, though I am not sure how much of that argument is true about high frequency traders. These types of activities in the market are speculations, it is not investing.

On the other hand of the spectrum, there is the long term investing. Long term investors buy shares of companies that they want to “own”. I fall in this category. By owning part of the company, I am owning part of the future profit potential of the company. I buy the shares if I believe the shares are selling at a cheaper price then current value of its future expected profits. Conceptually, other than the lack of direct control of the firm, it is no different than buying a business to own and operate it — you like the business prospects and you think the price is cheap or reasonable. This is what I think when I refer to “investing”. Before investing in a stock, I analyze the business prospects of the company and estimate a range of intrinsic value of the business in order to decide whether to buy or not. Again, the process is no different from what a rational person will do if he/she is looking to buy a company to own and operate.

Once I buy the stock, I keep an eye on the financial and business news to see whether the thesis is playing out as expected. As long as the business is continuing to perform, I just hold the shares for years. So, most of the cases I hold the shares for 3-4 years or more unless the investment thesis turns out to be wrong or changes along the way. However, I do speculate occasionally. But, those are a small fraction of my entire portfolio.

More specific analysis on one of my long term investments in the next post.

Tags: Philosophy