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The Investor vs. Speculator

Why Stocks Become Over / Under Valued - Investing Lesson 2

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Over the course of the past several decades, the term "investor" has been used for anyone who owns a share of stock. It is important that you understand this is not the case. When a person buys a stock, they are doing it as one of two people: either an investor or a speculator.

What's the difference? An investor is someone who carefully analyzes a company, decides exactly what it is worth, and will not buy the stock unless it is trading at a substantial discount to its intrinsic value. They are able to say, for example, that "Company 'X' is trading for $48 per share, but it is worth $62 per share." They make their investment decisions based on factual data and do not allow their emotions to get involved. A speculator is a person who buys a stock for any other reason. Often, they will buy shares in a company because they are "in play" (which is another way of saying a stock is experiencing higher than normal volume and its shares may be being accumulated or sold by institutions). They buy stock not on the basis of careful analysis, but on the chance it will rise from any cause other than a recognition of its underlying fundamentals. Speculation itself is not necessarily a vice, but its participants must be absolutely willing to accept the fact that they are risking their principal. While it can be profitable in the short term (especially during bull markets), it very rarely provides a lifetime of sustainable income or returns. It should be left only to those who can afford to lose everything they are putting up for stake.

How do these two different types of activity affect stock price? The speculator will drive prices to extremes, while the investor (who generally sells when the speculator buys and buys when the speculator sells) evens out the market, so over the long run, stock prices reflect the underlying value of the companies. If everyone who bought common stocks were an investor, the market as a whole would behave far more rationally than it does. Stocks would be bought and sold based on the value of the business. Wild price fluctuations would occur far less frequently because as soon as a security appeared to be undervalued, investors would buy it, driving the price up to more reasonable levels. When a company became overpriced, it would promptly be sold. Speculators on the other hand, are the ones who help create the volatility the value investor loves. Since they buy securities based sometimes on little more than a whim, they are apt to sell for the same reason. This leads to stocks becoming dramatically overvalued when everyone is interested and unjustifiably undervalued when they fall out of vogue. This manic-depressive behavior creates the opportunity for us to pick up companies that are selling for far less than they are worth.

This leads to a fundamental belief among value investors that although the stock market may, in the short-term, wildly depart from the fundamentals of a business, in the long-run the fundamentals are all that matter. This is the basis behind the famous Ben Graham quote "In the short-term the market is a voting machine, in the long-term, a weighing one." Sadly, some reject this basic principle of the stock market. Several months ago, I received an email from a reader who asserted that "the economic fundamentals of a company have no relation to the stock price." This is completely false. My response was a simple message that read "If fundamentals don't matter, what if Coca-Cola never sold another bottle of Coke? How long do you think the stock price would stay at its current level?" When put in this light, the folly of the "fundamentals don't matter" becomes evident. The next time someone preaches this, simply ask "what happens to the stock if the company can't make its payments and defaults on its loans?" When they answer "it goes bankrupt", simply smile and walk away. Fundamentals do matter.

Unfortunately, countless investors believe the myth this gentleman does. The perfect example of this is the dot-com boom of the late 1990's. Companies that generated no profit and had very little, if any, book value were selling at astronomical levels. "Surely this would prove that fundamentals mean nothing," some would argue. On the contrary, it proves our point entirely. Only a few short years after the initial stock market bonanza, the economic realities of these companies came back to haunt them. Most fell 90% or more from their highs, with many more going bankrupt, ultimately worth less than the paper their stock certificates were printed on.

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This page is part of Investing Lesson 2 - What Makes Stocks Become Over or Under Valued. If you have already read this lesson, you can skip directly to the Investing Lesson 2 Quiz.

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