A Primer on Investing
Investing is the act of deploying your savings to generate returns. The approaches towards investing can be classified into five broad categories:
Fixed income investments
Investing based on technical analysis
Investing based on fundamental analysis
Global macro investing
Fixed income investments
Considered to be the most prudent, conservative, or safest way to invest, it is also the worst way to invest. Across the world, the income derived from such investments is less than the official inflation rate of that country. Compounding the problem, the income is taxable. That is, the government acknowledges that the purchasing power of your principal is reduced each year, plus it taxes you on the income to ensure you become even worse off! That said, you have the greatest odds that your principal will retain its nominal value with fixed income investments.
Investing based on technical analysis (chartists, day traders)
Prices are discovered in the market every day. A chart pattern can tell you how a security (a security is any asset that trades on a public exchange) has been priced in the past, which is as good a guide as you can get when you’re new to the market and looking to buy. Chart patterns indicate trends, which some investors use to time their buy and sell decisions. While there is no guarantee, you are statistically more likely to generate steady returns over time, provided market behaviour does not change due to unforeseen circumstances.
Investing based on fundamental analysis (value investors)
This is the credo of the value investor a la Peter Lynch or Benjamin Graham or Warren Buffet. The value investor sees a mis-pricing in the market, and takes a position hoping to profit when the market corrects the mis-pricing. The value investor operates over a longer time horizon, and is patient, as markets may take their own sweet time to recognize and correct the mis-pricing.
“..the owner of equity stocks should regard them first and foremost as conferring part ownership of a business. With that perspective in mind, the stock owner should not be too concerned with erratic fluctuations in stock prices, since in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine (i.e. its true value will in the long run be reflected in its stock price).”
– Benjamin Graham, the father of value investing.
Global macro investing (hedge funds)
A fixed income investor invests only in debt instruments, a chartist focuses on the short term opportunities in a listed security, and a value investor focuses on the long term opportunities in a listed security. The global macro investor, on the other hand, focuses on macroeconomic trends that are happening, and looks at developing trading ideas to take advantage of those trends. He evaluates trades across all asset classes – fixed income, stocks, futures & options, currencies, commodities – across the global markets. This approach was born somewhere in the 1970s (think George Soros and Jim Rogers of the Quantum Fund) and is now quite the rage, with several hedge funds (and independent investors) adopting this approach to investing. The funds adopt leverage (i.e. take on debt), thus amplifying their gains and losses by several orders of magnitude over their equity capital. It’s one of the riskiest, and at the same time, most rewarding approaches to investing.
The idea behind this approach is to not lose money. A diversified portfolio should, in theory, perform well under any market conditions. The theory is that investments in such a portfolio are uncorrelated or negatively correlated, thus balancing out their effects and achieving steady, smooth returns over time. This does not work as well in practice, as markets tend to feed off one another – a trend affecting one market is highly likely to cross over into other markets. After all, capital moves globally, hence it is impossible to contain the effects of market movements without shutting off an economy from the external world (think North Korea).
So, what kind of investor are you?
All of the above is a valid answer. Think of these categories not as mutually exclusive but rather as tendencies. One tendency will dominate, but would be reinforced with the other tendencies. For instance, a chartist won’t use past data alone if he knows that new information will quite likely change future prices. A fixed income investor won’t stick to only government bonds if inflation spikes and bonds lose value.
Investment vs Speculation – is there a difference?
The answer varies depending on whom you talk to. Some say an investor looks at the long-term while the speculator looks at the short-term, or that an investor looks for steady returns while a speculator makes skewed bets for asymmetric rewards. Value investors consider all other approaches to be speculation. There are as many answers to this question as there are investors (or speculators), and again, you would probably be both.
The two best definitions I have found:
Investing – Investing is the act of putting capital into a business in anticipation of making a profit
Speculation – Speculation is allocating capital in order to profit from distortions in the market caused by government intervention