Part II of our look at investment strategy vs speculating

Last month we wrote about Investing vs. Speculating – Part I, during which we discussed two key ideas. The first was based on an article that Warren Buffet had recently written where he discussed some of his most successful long term investments. The second, which was tied directly to the first, was about 2 imaginary lemonade stands. (Click here to read Investing vs. Speculating – Part I).

You used the word investing but what you really meant is speculating

Recently, I was at a restaurant with one of our clients when they asked me about investing in exotic things like currency futures. She said she didn’t know much about them but heard they were quite lucrative. I responded by saying “you used the word investing but what you really meant is speculating.” This of course threw her for a surprise, and she asked “what’s the difference?”

I responded by using the restaurant we were sitting in as a perfect example.  I said “imagine that your son comes to you and says I want to buy this restaurant and I would like you to invest in it with me. Quite naturally you would ask some questions. How many people ate here last week? How about last month? How about last year? How do these numbers compare to previous years? What’s the trend line from month to month? How much does the average person spend when eating at this restaurant? What are the restaurant’s costs? Do they own the building or lease it? If they lease it when does their lease expire? Who are the closest competitors? What does their profit & loss statement look like for the past 3 years? How about their balance sheet? What could go wrong and what haven’t I thought to ask!

Your son has done his homework; he is prepared to answer all of these questions (and more). In addition, he can tell you that the seller is looking to retire but the head chef has agreed to stay on for at least 5 more years as has the general manager. The asking price is not cheap, but it’s not outrageous either. His CPA has crunched the numbers and he thinks the price is very reasonable.

However just as you are about to write the check, your other son comes in because he has an investment idea that he wants to share with you. He wants you to invest in the hedge fund he is about to start, which is going to buy and sell commodity futures. Now this may sound absurd but over the past year he’s invested all of his IRA into this strategy and he’s up 150%! He can’t tell you exactly what his formula is because he admits it’s largely based on his gut instinct.

While success is not guaranteed, the probability of success is in your favor

Now without knowing much more than what I’ve shared, you can quickly surmise that one of these is an investment, and the other is speculating. In the first example, you are investing in a long term business proposition supported by historical results and thorough due diligence. While success is not guaranteed, the probability of success is in your favor. The second example is pure speculation. You may hit a home run and double your money, but you may also swing and miss and lose it all.

The bottom line is when it comes to your investments; make sure you know when you are investing and when you are speculating.