Sunday, January 10, 2010

The Definition of Speculation, as Opposed to Investing (by some really smart economists)

In a book so mind-blowingly insightful that I had to stop marking because the whole page was turning red, I read the most concise, precise, comprehensive, and accurate definition for speculation: "buying commodities for the capital gain from anticipated increases in their prices rather than for their use."

As an example, buying oil or wheat to have fuel or grain is not speculation, but buying them to trade them to someone else after their value rises is.  Note that it is only speculation if the gain on the commodity is a capital one rather than an operating (or ordinary income) one.  In other words, if you are a distributor, retailer, broker, or trader of oil or wheat, you are not speculating.  The precise difference between a capital gain and an ordinary gain on a commodity can be fuzzy in some cases, but in general is quite clear.

Once speculation is defined that way, the next step is to consider the special case where the commodity is a stock. Stock is definitely a commodity: one share of a given class of stock in a given company is completely exchangeable for another share of the same class of stock in the same company. Most other securities are commodities as well.

In the case of a security, a capital gain is the result of income from selling the security at a higher price than paid for it.  Operating income is the dividends or payments from the security during the period that it is held.

This definition might miss a few cases in its simplicity, such as growth stocks that don't pay dividends, but it's pretty much spot on.

The books is Manias, Panics, and Crashes by Charles Kindleberger.  Kindleberger was a professor of economics at MIT for 30 years, and his book is widely cited by other books on market cycles such as Bull! by Maggie Mahar, which is where I read about it.

2 comments:

  1. So how does any individual invest without speculating? Or, how do we now separate individuals who are investing in a manner consistent with stable growth from those doing it in a manner inconsistent?

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  2. Good question (and thank you for posting!). The basic idea is that if you are investing for income then you are not speculating. Income can be rent (if the asset is real estate), dividends (if the asset is stock), interest payments (if the asset is bonds or other "fixed-income" securities such as securitized mortgages), or operating income from productively using the assets (if the assets are means of production such as machinery or other equipment).

    The Minsky model takes this definition a step further and says that if you are borrowing money to purchase the asset, and your operating income is not enough to cover your interest and principal payments on the borrowed money, then you are speculating (or worse). I covered this in more detail in my latest post here.

    The neat categories break down a bit when you think you are investing in a stable manner, but in reality are speculating due to overly optimistic income projections. Still, at least in this case you are generally more protected than if you did not anticipate any income but merely short-term capital gains from executing a "flip."

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