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What is investing versus speculating?

By ATB Investment Management Inc. 6 March 2020 6 min read

 

Speculation is investing in a stock or bond with the hope that it will increase substantially in value, while ignoring the substantial risk of losing value. Chasing returns can be the purest form of speculation. It seems logical to invest to potentially increase our wealth. However, chasing performance by speculating can have the opposite effect, and can negatively impact portfolio value and our hard-earned money.

As humans, we are largely driven by our emotions, and sometimes our emotions lead us down the path of irrational decision making. I am sure we can all remember a time when our emotions led us to splurge on a purchase that we didn’t really need, indulge in an extra piece of dessert, or even get mad at our partner or children. Those same emotions can drive us to make poor portfolio decisions. It is tempting to want to sell your investments when you are earning 8% and you are being pitched another portfolio that is earning 10%. Our emotions may sway us to focus solely on the 10% earnings and we might not pause to think about the volatility of the portfolio, the additional fees, or the past performance of the fund. We can be blinded by our emotions and the lure of earning more.

 

In his book, Predictably Irrational, Dan Ariely, Professor of Psychology and Behavioral Economics at Duke University, blames our lack of self-control on our two states of judgment: hot state and cool state. In our cool state, we are able to make rational long-term decisions. Alternatively, in our hot state, we tend to give in to instant gratification and make rash decisions.

Our hot state can also represent our “speculating” state. This is when we are more inclined to make investment decisions based on our feelings vs. using sound judgement. In our hot state, we are more inclined to invest our hard-earned money in a stock that seems to be on a never-ending upward ride. In contrast, our cool state is when a level-head prevails and we are able to make sound investment decisions based on well-thought-out financial plans. Let's review the roles of speculators vs. investors.

 

"Money flows into most funds after good performance, and goes out when bad performance follows."

John Bogel

 

Top 10 things speculators do

  1. Make investment decisions purely on media coverage.
  2. Invest in “hot-stocks” talked about at dinner parties or in financial media.
  3. Often incur more trading fees and taxes associated with overbuying/overselling.
  4. Feel more nervous around natural stock market fluctuations.
  5. Feel a greater sense of panic when prices drop, often selling and redeeming for cash.
  6. Pay more attention to the potential gains of an investment, and little to the potential losses.
  7. Invest for the price movement of the stock (short term), not to participate in the long-term growth of a quality company.
  8. Often end up buying at a high price (when our emotions are saying we can’t miss out) and selling at a low one (when our emotions are in defeat mode).
  9. Mistake the pure luck of investing in a profitable trade as the skill of being great at stock selection.
  10. Ignore mean reversion in the stock and bond market.

 

Top 10 things good investors do

  1. Resist the temptation to buy into investment fads or trends in the media.
  2. Invest for long-term growth participation in quality companies.
  3. Invest according to a well-thought-out plan that considers one's life and financial goals.
  4. Understand the risks associated with investing, and invest in a plan with an acceptable level of volatility or price movements.
  5. Pay less attention to the day-to-day price movements of their holdings.
  6. Refrain from panicking when markets are in a downward cycle.
  7. Invest in a diversified portfolio of stocks and bonds (or all stocks, if that is what has been deemed appropriate).
  8. Invest for long-term wealth creation, not a perceived feeling of an overnight jackpot of wealth.
  9. Go to parties to have fun and good conversation, not to seek out stock tips.
  10. Trade less frequently.

 

How working with a professional can help

As with most things in life, a trusted professional like a financial advisor can help cut through the noise and focus on what really matters. Financial advisors can help you navigate life’s twists and turns. They are there to help uncover your financial and life goals and set you up on the path to achieving those goals.

In many ways, they are like the navigation in your car; they help provide the most efficient route possible for your investment journey. The same way navigation can reroute you due to unexpected traffic ahead, an advisor can help make adjustments to your plan to accommodate for life’s unexpected adventures.

A financial advisor is also there to help when emotions are running high. Perhaps, we are in an economic cycle where we are seeing bubbles, meaning specific stocks or sectors are experiencing extreme gains. Bubbles often drive the desire to jump in and earn what appears to be easy money. An advisor can help discuss the risks associated with buying during bubbles. They act as an emotional compass and help when we enter into a hot state of speculation due to markets being uncharacteristically high or low. It’s important to pause and reflect on one's financial plan and how short-term emotional decisions made today, can have a lasting impact on our long-term financial well-being.

 

In the end

One of life’s greatest challenges is managing our emotions. Whether it is curbing the urge to get angry when someone cuts in front of you in a long line or resisting the temptation to invest in the next perceived Apple or Google, our emotional responses rarely result in our desired outcome.

When it comes to investing, the hallmarks of a great strategy involve patience, discipline and a well crafted financial plan. A plan that incorporates the inevitable volatility that one will experience as a long-term investor. Success ultimately lies in one's ability to be patient and remain invested throughout multiple market cycles. Doing so helps your portfolio compound over time, meaning you can achieve your financial and life goals quicker. Investing should be boring to allow you to focus on living your best life without the constant worry of the markets.

 

If all humans are susceptible to emotional decision making, what is ATB Investment Management Inc. (ATBIM) doing differently?

As a fund company, we make every effort to take our emotions off the table and utilize a multi-manager approach to help produce a resilient portfolio for our clients. In using what we call sub-advisors, we can objectively evaluate their buy and sell decisions and ensure they are adhering to the strategy that we have hired them for. This can help to eliminate the emotional biases that may exist in us as humans. For example, we may fall in love with a company or become close with management teams and hence become biased in our thinking.

At ATBIM, we are also there to ensure our sub-advisors are not falling victim to emotional decision making by holding them accountable for the portfolio decisions they make. We question sub-advisor’s buy and sell decisions and ensure that decisions are based on rational judgments and valuations, as opposed to feelings. As a client, this means you are buying a portfolio of quality companies with strong valuations, which should help limit the volatility you incur. Ultimately, this increases the chances of our clients remaining invested in the market, enjoying the benefits of compound growth over time, and ultimately enjoying a larger retirement pie.

 

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