Investing vs Speculating 3

Foreword

I want to start by noting that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, via some formal classes, but mostly self-taught.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

This post is a continuation of Investing vs Speculating and Investing vs Speculating 2. If you have not read those posts yet, you probably should before continuing here. A separate related post, Zero Sum Game, finally rounds up why understanding investing vs speculating is important.

Starting to invest

Whenever someone asks me for newbie investment advice, I almost always tell them the same things:

1. Read “The Intelligent Investor: The Definitive Book on Value Investing“.
   • It is outdated, but contains a lot of still useful information.
2. Then chase down all the bits that seem wrong/outdated, and in doing that research, hopefully you’ll understand the topics better, and more importantly, understand yourself better.
3. Finally, you need to decide what kind of person you are.
   • Are you an investor? If so, which kind?
   • Are you a speculator?  If so, which strategy appeals to you more?

Only then, can any sort of useful advice be given.

This is also why whenever you open a brokerage account, the broker always asks you whether you are “hedging, seeking income, seeking growth, etc.”.

Essentially, they are trying to understand which of the above modes apply to you best, and when. And in so doing, they can better tailor their recommendations and advice for you.

I are investor

Not everyone is suited to be an investor.

Some people simply cannot stomach the paper losses that investing sometimes entails. It takes a special kind of crazy, masochistic instinct for someone to look at your portfolio which is down 50%, and think, “OMG, I MUST BUY MORE!“

If you are unable to stomach such losses, and you are also terrible at speculating, then I suggest buying illiquid assets, or simply don’t look at the stock markets at all, after you do your research and have bought.

I won’t lie — doing this is dangerous! You may miss when fundamentals really do change and your model needs updating.

But it’s better than constantly panicking at the slightest dip. If nothing else, you’ll sleep better.

I value value investing

If you are value investing, you typically put in a lot of work per company, which means you likely won’t have time to invest in too many companies. As such, diversification is rare in value investing (remember Buffett’s quote about being “too diversified”).

On the other hand, if you are macro/passive investing, you mostly only consider macroeconomic issues and/or your personal temperament and needs, both of which apply to large swaths (or even all) of companies. As such, diversification helps to dilute the idiosyncratic risks of investing in individual companies.

These are not black/white extremes, it is a spectrum.  The more you are willing to dive into the details of companies, the less you should diversify — the more you are sure of a company, the more you should concentrate your bet.  The less you are willing to dive into individual companies, the more you should diversify to avoid idiosyncratic risks that you’ve overlooked.

I R speculator

If you are speculating, then there is always the element of “what if you’re wrong”.  Combined with the lack of a fallback in terms of earnings, a wrong bet can be disastrous.

As such, successful speculators generally employ very robust risk models, where they:

1. Limit exposure to each bet (i.e: position sizing)
2. Limit increasing exposure as the bet works (i.e: take profits if the bet works out well)
3. Limit downside risk (i.e: cut losses if the bet is souring)

Yes, it seems like everything says “don’t bet”, that’s not quite true.  It’s a matter of degree, and depending on your strategy (momentum, mean reversion, event driven or arbitrage), one or another of the 3 factors dominate.

For example, if you are betting on momentum, you typically use small bets on many names.  When momentum bets pay off, they tend to pay off big, so even small bets will make a meaningful difference to your entire portfolio.  At the same time, you cast a wide net, because you want to ensure that you catch at least a few of the momentum runs.

In momentum bets, limiting downside risk is generally easy — at some point, your momentum model will tell you that momentum is in the opposite direction, which is when you close out the position and/or go short.

But taking profits on the upside is generally hard — typical momentum models will suggest you buy more as the stock rises, because it has more momentum!  So (b) is where your risk model should concentrate, for momentum models.

For mean reversion models, the opposite is true — as the stock goes up, your model will naturally tell you to start shorting, while as the stock tanks more, your model will tell you to buy more, potentially catching a falling knife.  So for mean reversion, your risk model should concentrate on (c).

Risk models should be crafted carefully with an understanding of the primary model.

Stay true

Whatever you choose to do, be honest with yourself, and be very clear:

1. What you are doing
2. How you will make a profit
3. When you should reevaluate and/or cut losses

If you invest blindly without understanding what you are investing in, you are not even speculating — you are purely gambling.

If you speculate blindly without understanding your exit criteria, you are also just gambling.

Gambling is fine, I have nothing against gambling — but understand that when you gamble, you are paying a fee to be entertained.  So gamble if you want, just don’t expect a (positive) return.