Smart Investment Strategy vs. Casino-style Gambling

I recently read a great article by Warren Buffett (which I am happy to share) where he talked about two great investments that he made and why they worked out as well as they did. The point of Buffett’s article was that in both cases he was investing as opposed to speculating. While most investors are certainly familiar with these terms in general, they are unfamiliar with how these terms apply to an investment.

Warren Buffet discussing wealth preservation strategies

In order to explain the difference between investing vs. speculating let’s use two different imaginary lemonade stands.

The first lemonade stand has a 30 year lease right outside of a location where hundreds of pedestrians walk by each day. They sell high quality lemonade and because of the convenience of their location, are able to command a slight premium over what you pay at the grocery store for lemonade. This lemonade stand has been in business for over 20 years and has a history of producing 15%-20% profit margins. The owners of this lemonade stand decide to they want to expand their business by offering cookies and they need raise capital in order to do this, so they issue stock in the company.  They plan to pay a dividend to shareholders and plan to increase this dividend over time as the business grows and profits increase.

The second lemonade stand does not have the history or the stability of the first, but they have something that they think is even more valuable – a patent. Their lemonade may cure baldness. They are still in clinical trials and their product has not been FDA approved, but once (if) it is they will be able to sell each cup of lemonade for 20X what the going rate is! They are currently not profitable because they are sinking all of their revenue into research and development but they hope to be profitable in the future. They are also looking to raise capital as they were initially funded by some venture capitalists who are not willing to commit any more seed capital to this company.

You’ve probably guessed it by now, the first company represents an investment. Stable earnings history, profits, and a dividend. The second represents speculation, an idea, a potential growth story. There is nothing wrong with either one of these investments, as long as you understand the risk/reward trade off. The first company is likely to produce stable growth over the years but is not going to make you rich overnight. However they are also very unlikely to make you go broke either. The second company has the potential for rapid growth, they could be the next Google for all we know. But they could also crash and burn and lose all of your money.

They could be the next Google for all we know. But they could also crash and burn and lose all of your money

Most people lump all stocks into the same category, and unfortunately, that is the category that company two is in. They feel like the stock market is a giant casino where you are speculating each day on which companies will grow and which will shrink. While there is an element of this, it is not the majority of stock investments and is certainly not how we manage our clients’ hard earned savings.

We will expand on this idea with our next article – Investing vs. Speculating – Part II