04 Nov 2008

It's Still Your Grandfather's Stock Market

One of my favorite uses for Google Reader is to keep an eye on the feed of latest releases from Project Gutenberg and Distributed Proofreaders. Although the great majority of what they archive is of limited interest (at least to me), every once in a while something really cool comes through.

“Successful Stock Speculation,” (HTML version) originally published in 1922, is worth a read. Written as a handbook for the novice investor, just about everything in it is still good advice. I suspect that if more amateur (by which I mean, using their own, as opposed to someone else’s, money) speculators stuck to the very conventional wisdom in the book, far fewer people would lose their shirts in the process.

[The word ‘speculator’] refers to a person who buys stocks for profit, with the expectation of selling at a higher price, without reference to the earnings of the stock. … An investor differs from a speculator in the fact that he buys stocks or bonds with the expectation of holding them for some time for the income to be derived from them.

This is an important distinction which, sadly, seems to have been lost recently. There’s a fundamental difference between speculation and investment; people who buy and hope for a change in price of the underlying asset, so that they can sell and realize a profit, are not investing. They are speculating. This is true whether the underlying asset is stocks, bonds, or real estate. I’d argue that misunderstanding the difference between the two is the root cause of virtually all market ‘horror stories’ (Grandma and Grampa wiping out their retirement, the kids’ college fund, etc.).

As a usual thing, it is a good time to buy stocks when nearly everybody wants to sell them. When general business conditions are bad, trading on the stock exchanges very light, and everybody you meet appears to be pessimistic, then we advise you to look for bargains in stocks. […] When business is bad, nearly everybody thinks business will be bad for a long time, and when business is good, nearly everybody thinks business will be good almost indefinitely. As a matter of fact, conditions are always changing. It never is possible for either extremely good times nor for extremely bad times to continue indefinitely.

Sound familiar? There’s nothing new here; you could read practically the same thing in just about any Warren Buffett book. But the fact that it still works so well, so unusually well in fact, is a testament to how many people just don’t seem to get it.

The same could be said for the book’s advice on picking which stocks to buy:

We maintain that there is only one basis upon which successful speculation can be carried on continually; that is, never to buy a security unless it is selling at a price below that which is warranted by assets, earning power, and prospective future earning power.

Today we might call this “intrinsic value” or “fundamental value,” and this school of thought ‘Value Investing’ (although, for the reasons noted above, chances are it’s not really “investment” but rather ‘value-driven speculation’).

Although other strategies seem to get all the attention during bull markets, it’s the unsexy science of fundamentals that has seemingly withstood the test of time, and is still as useful today – regardless of what the future might hold – as it was in the early 20s.

This entry was converted from an older version of the site; if desired, it can be viewed in its original format.