Ben Graham believed in separating investing from speculation. But he also separated speculation from intelligent speculation because some amount of speculation always exists in prices. The reason: the future is uncertain.
Because the future is uncertain, the market is the collective best guess on what will happen next. But Graham knew that Mr. Market sometimes guesses wrong. Therein lies the opportunity for investors willing to focus on facts in a way that puts the odds in their favor.
I’ve highlighted pieces of a Ben Graham lecture the past couple weeks. In his last lesson, Graham offers a framework for thinking about investing, intelligent speculation, diversification, and probabilities that are worth reading.
On investing versus speculating:
First, what do we mean by speculation? There is a chapter in our book on Security Analysis which is devoted to the distinctions between investment and speculation. I don’t wish to repeat that material beyond recalling to you our concluding definition, which reads as follows:
“An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
Speculative operations are all concerned with changes in price. In some cases the emphasis is on price changes alone, and in other cases the emphasis is on changes in value which are expected to give rise to changes in price. I think that is a rather important classification of speculative operations.
On why some speculative element always exists in prices:
That arises from the fact that investors have been willing to pay so much for so-called quality, and so much for so-called future prospects, on the average, that they have themselves introduced serious speculative elements into common stock valuations. These elements are bound to create fluctuations in their own attitude, because quality and prospects are psychological factors. The dividend, of course, is not a psychological factor; it is more or less of a fixed datum. Matters of the former kind — I am speaking now of prospects and quality — are subject to wide changes in the psychological attitude of the people who buy and sell stocks.
On speculation versus intelligent speculation:
Intelligent speculation presupposes at least that the mathematical possibilities are not against the speculation, basing the measurement of these odds on experience and the careful weighing of relevant facts.
On why intelligent speculation, combined with diversification, works when accounting for probabilities of success:
If the probabilities, as measure by our mathematical test, are definitely in favor of the speculation, then we can transform these separate intelligent speculations into investment by the simple device of diversification. That, I think, is a clue to the most successful and rewarding treatment of speculation in Wall Street. The idea, in fine, is simply to get the odds on your side by processes of skillful, experienced calculation.
Going back to our Electric Bond and Share example, if we really are skillful in our evaluation of the possibilities here, and reach this conclusion of a 50-50 possibility, then we could consider Electric Bond and Share Stubs as part of an investment operation consisting of, say, ten such ventures of a diversified character. For in ten such operations you would get $50 back for an investment of $30, if you have average luck. That is, you would get ten dollars each on five of them and you would get nothing on another five, and your aggregate return would be $50.
Very little has been done in Wall Street to work out these arithmetical aspects of intelligent speculation based on favorable odds. In fact, the very language may be strange to most of you. Yet it oughtn’t to be. If we are allowed to commit some misdemeanor by making some mild comparisons between Wall Street and horse-racing, the thought might occur to some of us that the intelligent operator in Wall Street would try to follow the technique of the bookmaker rather than the technique of the man who bets on the horses. Further, if we assume that a very considerable amount of Wall Street activity must inevitably have elements of chance in it, then the sound idea would be to measure these chances as accurately as you can, and play the game in the direction of having the odds on your side.
I should greatly welcome an effort by security analysts to deal intelligently with speculative operations. To my mind the prerequisite here is for the quantitative approach, which is based on the calculation of the probabilities in each case, and a conclusion that the odds are strongly in favor of the operation’s success. It is not necessary that this calculation be completely dependable in each instance, and certainly not mathematically precise, but only that it be made with a fair degree of knowledge and skill. The law of averages will take care of minor errors and of the many individual disappointments which are inherent in speculation by its very definition.
It is a great mistake to believe that a speculation has been unwise if you lose money at it. That sounds like an obvious conclusion, but actually it is not true at all. A speculation is unwise only if it is made on insufficient study and by poor judgment. I recall to those of you who are bridge players the emphasis that the bridge experts place on playing a hand right rather than on playing it successfully. Because, as you know, if you play it right you are going to make money and if you play it wrong you lose money — in the long run.
There is a beautiful little story, that I suppose most of you have heard, about the man who was the weaker bridge player of the husband-and-wife team. It seems he bid a grand slam, and at the end he said very triumphantly to his wife, “I saw you making faces at me all the time, but you notice I not only bid this grand slam but I made it. What can you say about that?” And his wife replied very dourly, “If you had played it right you would have lost it.”
There is a great deal of that in Wall Street, particularly in the field of speculation, when you are trying to do it by careful calculation. In some cases the thing will work out badly. But that is simply part of the game. If it was bound to work out rightly, it wouldn’t be a speculation at all, and there wouldn’t be the opportunities of profit that inhere in sound speculation. It seems to me that is axiomatic.
Ben Graham Lectures: Current Problems in Security Analysis
Steven Crist on Why Investing is like Horse Racing