Are Stocks Risky Investments? Not if You Do it This Way.


by Daniel Sparks

writer at

the Motley Fool

Are Stocks Risky?

These days when someone mentions “stocks” it results in negative connotations. The myth is that stocks are risky and this train of thought is valid to a certain degree. However, considering the majority of individuals investing in stocks do so with little to no discipline and are seeking short-term gains. The most common negative connotations from the word “stocks” are:

  • Too risky
  • Gambling
  • Confusing

But when the word “business” is used in place of “stock,” these negative connotations seem to fade. Repeat these two questions to immediately notice the difference.

Are stocks risky?

Are businesses risky?

Stocks are Risky for Speculators

There are really two types of people who buy and sell stocks:

1. Speculators: Those who try to profit from guesses and hunches as well as on the movement of stock prices
2. Investors: Those who try to buy great businesses at good prices to realize a gain in the long run

Speculators are not investors at all. This type of person simply focuses on the stock and the price. They do not know anything about how the company is run, what the company plans are and how well it has been doing.

Investors, on the other hand, focus on the business, just like how a real businessman focuses on day to day operations and tries to maximize the value of his business.

When you read books that suggest stocks are risky, without distinguishing between speculators and investors, the author is either:

1. not aware of the difference between the two or
2. is ignorant of how significantly different they are

When I first learned finance I was taught that investing in individual stocks is risky. It was gambling and you should invest in mutual funds that are highly diversified so you can earn the returns of the market.

To put it bluntly, this is an ignorant understanding of finance and constantly regurgitated without being corrected. The reason people quickly make these assumptions regarding stocks is because they haven’t done enough study to realize that speculators and investors are drastically different.

Benjamin Graham, often referred to as the Father of Value Investing, was one of the first individuals to make sense out of investing in stocks and squash the myth that stocks are risky.

What is The True Definition of “Stock Investing”?

Let’s look at Graham’s definition of investing.

“An investment operation is one which, upon thorough analysis, promises safety of principle and an adequate return. Operations not meeting these requirements are speculative.” – Benjamin Graham

If this is true, then anyone who invests without considering what the business is worth is a speculator. There are tools such as the OSV Stock Valuation Models that help with valuing the intrinsic value of stocks to identify what a stock is worth.

But let’s stop and explain what we mean by some of these investing terms.

Intrinsic value: the real value of the business derived from fundamental analysis.

Fundamental analysis: the analysis of profitability, tangible assets, and cash flow derived from financial statements, SEC filings, and other facts regarding the business (income statements, balance sheets, and cash flow statements etc.) to assess the intrinsic value of a business.

Speculator vs Investing Example

Let’s explain this as an example.

If you wanted to buy a rental property you would want to know what you’re buying, right?

If you are a smart investor you would take a look at the neighborhood, history of what renters have paid for rent in the past, history of what renters are paying for houses nearby, the number of rentals that are not occupied nearby, and the tangible value of your house: walls, rooms, fixtures, condition, basement, etc. You would most likely consider many other factors as well.

This is fundamental analysis.

On the other hand, what if you approached buying your rental from a speculative approach? There are many speculative approaches, but let’s consider a few:

1. Buy a rental property based on the fact that the selling price of the property has been rising faster than other houses over the last last 2 years.
2. Buy a rental property because the price is 30% lower than it was last year.
3. Buy a property because you speculate that the city is going to eventually buy the property from you at a high price to develop commercial space for the city.

None of these reasons, by themselves, take into consideration the intrinsic value of the property. And without taking the intrinsic value into consideration, how can you ensure “safety of principle and an adequate return?”

It’s impossible.

Are Stocks Risky? Not if You Invest.

You need to know the value of what you are buying. Maybe the price has shot up over the past two years, but maybe this was simply because buyers were simply overpaying. Maybe the price is 30% lower this year than it was last, but maybe this was simply because the basement was flooded, severely damaging the foundation of the house. Maybe it is possible that the city will eventually purchase the property for a higher price than what you paid for it, but if it doesn’t, and you never did your fundamental analysis, there is the possibility that you overpaid for the property and could incur a serious loss.

The same goes for stocks. Think of it as if you are buying a business as a whole. You would search for a great business, analyze the facts, and then estimate its intrinsic value.

Then, because of the time value of money and because not everything always goes as predicted you would only purchase at a discount to fair value, allowing for a margin of safety.

When you buy a stock you are simply buying a share of a business.

Why then, would you approach the purchase of stocks any differently than the approach of buying businesses as a whole? I doubt it is very often that someone buys an entire business for speculative reasons. They most likely gather all the facts, do fundamental analysis, calculate the intrinsic value, and offer to buy the business at a price that seems like they will receive true value for the price they paid to protect their principal and ensure an adequate return.

Investing this way takes discipline and patience.

Most people are satisfied to remain ignorant, keeping it simple: “investing in individual stocks is risky,” “mutual funds are diversified and will keep you from loosing your money like you could in stocks,” “investing in individual stocks is gambling.”

Whether or not investing in stocks is gambling depends on whether or not the investor is a true investor or a speculator.

  • Very well written.

    …but the definition of “investors” misses the mark. By only including “Those who try to buy great businesses at good prices to realize a gain in the long run,” things like pair trading, NCAV investing, or just investing in a low p/b stock are left out. It would also leave out what Ben Graham and Warren Buffett themselves did, many years back. There are drastically more types of investing than just looking for great businesses at a good prices. I think this is a good example of the ‘Buffett Trap’ that many investors fall into. Buffett currently has a good investment method but it’s not the only great way to make money and it’s not even the best one around.

    I think that the best definition a person can use for investing is Graham’s which the author notes near the end of his article. Investing really is the protection of capital and chance for an adequate return after adequate analysis.

    Cheers,
    Evan

  • Pete A

    Certainly sounds reasonable. The real problem with this whole line of reasoning is the sensitivity of EVERY model to futuristic assumptions. I can make any stock seem under or over valued just by playing with the inputs such as interest rates. While this can be partially dealt with using the margin of safety you recommend, speculators can do similar things. Also, in a future post, how about combining investing with speculating? Seems that one could do the fundamental analysis, then apply speculator logic for timing.

    Anyway, thanks for a well written and interesting post.

  • Yesterday I wrote a post on the same topic. Great minds think alike ! (Just kidding).

    I think, the debate about what is speculation vs investing will continue to rage for years. For fundamental driven investors like us, it seems obvious that value based investing is the best approach to build long term wealth. But, I am sure folks who believe in short term trading strategies and speculation will make the same argument about their ideas. Again, without speculators and, therefore the liquidity, it will be tough to find bargains.

  • Evan, you were right. My investing definition was flawed. I should have stuck with Benjamin Graham’s definition. In reflection I realized I lost my way as I was writing the post and strayed from the purpose: to defend that stocks can be solid investments, far from gambling, just like real estate and buying or starting a family business.

    I have revised the post and feel much better about how I came across this time. You can check it out here: http://www.valuefolio.com/an-argument-for-stocks/

    Pete A, I do believe that futuristic assumptions are sensitive to error, but they are required for any valuation. Furthermore, “upon thorough analysis” I believe anyone can make sensible futuristic predictions as to “ensure safety of principal and a satisfactory return” as long as these futuristic predictions always lean toward conservatism.

    As for combining speculation and value investing, can you give me an example? I like to relate investing to buying a whole business or a rental. How do you think anyone could apply speculation in the purchase of a whole business or a rental property. If it can’t be done this way, why is it any different with stocks?

  • Value Investor

    I consider myself a value investor and I try to stay disciplined and patient when it comes to picking stocks. Buffett usually compares investing to a baseball player at bat, you don’t have to swing at every pitch, just the good ones which gives you a chance of a home run.

    When I do the analysis of companies I try to stay completely clear of forecasting future cash flows and earnings. There is so much uncertainty involved with this that I can’t justify basing my investment decision on it. I look at a company’s performance in the past and try to calculate the intrinsic value from there. One big assumption of course is that the company will be able to maintain the current level of performance. I’m pretty sure this was Graham’s standpoint as well.

  • Will

    I agree that predicting future cash flows and earnings is a ‘risky’ science. However, even erring on the side of caution and using the past as your guide, you are still predicting the future. You are predicting that the past will continue into the future and that past performance will equate with future performance. Even if you are buying securities for less than asset value or cash value, you are predicting that the price will eventually go up.

  • 100% agreed with Will. In addition, even balance sheet investing, to some extent, places some estimation on the future, because if the current management spends it unwisely in the future, it can take away the value we were counting on.

    I think the part about focusing on the balance sheet and assets is that it talks about value today – if the company has $10M after all liabilities of cash and it trades for $5M, well, you are effectively saying you’d buy the entire company for $5M, sell it for $10M, and pocket the $5M of profit. That makes sense – it’s a decision on the present day value, not the future.

    I don’t have too much of a point, other than that we should be cognizant of the risks at all times.

  • Gil Meriken

    The difference in investing is that there is a business-driven reason to purchase a stock, whereas in speculating, you are dealing with market psychology, momentum, and emotion. In the former, you are trying to estimate the value of a company, in the latter you are guessing the minds of other people. Both can bring you gains, but I’d rather trust my evaluation than hope to be able to read the minds of millions of people.

  • @ Daniel Your ability to be humble and open to the possibility of being wrong is rare and a great asset that will help you on your investment journey. I’m still trying to work on those things myself. Great writeup and happy investing.

    Cheers,
    Evan

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