Forum Archive Index - March 2004

["tennyson@caverock.net.nz" <tennyson@caverock.net.nz>]

Hi Gavin,

>
>> 2/ Speculation:
>> 3/ Investing:
> 
>They both utilise "speculative risk" - that is the _potential_ for
>upside and downside. Compare this with "pure risk", such as getting
>hit by a car, which is nothing but loss. These are common text-book
>definitions of risk.
>

I get the impression you might be mixing disciplines with your 
definitions.    

My own definition of 'risk' in the investment sense is the probability of 
suddenly losing a large part or all of my capital in a way that was 
unforseen.    The potential for upside is not risk.  I would not be at all 
perturbed if my investments doubled in value over a year!   There is 
*no risk at all* to me if that happens.    

There is an academic view out there that risk is correlated with return, 
and the upside is in some way irrevocably tied to the downside.  In my 
observation this is rarely true.  I am constantly amazed at the number 
of sharemarket investments around with widely differing expected 
returns, yet the same risk (my definition of risk).

'Pure risk' (as in being hit by a car) is an insurance term which, as I 
see it, has no relevance to discussion on investment.

> 
>As you suggest, pure speculation has no risk management behind it.
>

No I never said that.    Good speculators are very good risk managers.   
In fact risk management is the key to their success.  One of the best 
risk management tools a good speculator can have is the 'stop loss'.

>
>Investing on the other hand has more research and effort is put into
>treating (reducing, transfering) the downside risk, 
>

Not necessarily.   Plenty of people stick their money in bank account 
term deposits without doing much research at all.    Those people are 
undisputedly investors.  But how many of them check the credit rating 
of their bank before they invest?

OTOH speculators can be very sophisticated and put in a lot of effort.  
Share traders spend years studying books and familiarising 
themselves with complex software tools for instance.

>
>But investing is still dealing with a speculative risk,
>

No, investment is not speculative in the sense that return is tied to 
share price movement.    If an investor bought a share in a company 
on the sharemarket which he then decided (with others) to take private, 
he would not be concerned if the company was never publicly traded 
again.  A speculator OTOH would have no interest at all in following 
the fortunes of a private company.

>
>but analysis has hopefully reduced the downside 
>and increased the upside. 
>

I want to make the distinction here between 'ultimate' upside and 
downside and 'transient' upside and downside.

*All* investments and speculations have transient upside and 
downside.   House prices vary from month to month.   So does the 
value of 'fixed' term deposits.   But because these things are not being 
constantly revalued like shares are, people *perceive* houses and 
term deposits to be capital stable.  They are not.   However, most 
people who invest in term depostis are not concerned at valuing what 
they have each week.   They are interested in *ultimate* return, or what 
happens when they sell the house or the term deposit matures.  Quite 
rightly so in my view.    It is pointless worrying about the day to day 
flucuations of the worth of your term deposit or house, when all that 
really matters is what happens when you cash up.

All speculations and investments have transient uncertainty.    Trying 
to build the concept of transient upside and downside into the 
definition of 'investment' vs 'speculation' is futile.

For 'ultimate' upside and downside risk you ned to look at the size of 
the pie you are investing in.    If it is decreasing you are gambling.  If it 
remains the same size you are speculating.   If the pie is growing you 
are investing.   It really is that simple.

If you think that 'investment' will automatically reduce your downside 
risk over speculation you are wrong.   Say I buy a share at $4 and set 
at 'stop loss ' at $3.99.   This is a speculation that has almost *no* 
downside risk! 

>
>Put simply...
> 
>Speculation + Risk Management = Investing
> 

I don't know where that definition came from, but I would suggest it is 
totally wrong.    The idea that speculation does not involve risk 
management is demeaning and facile to professional speculators.

In the Graham and Dodd definition of 'speculation' and 'investment', 
risk managemt isn't even mentioned.   'Risk management' is an 
important but completely unrelated concept.

SNOOPY



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