Benjamin Graham, mentor to the greatest investor who has ever lived, Warren Buffett, said investing requires safety of principal and an adequate return.
Speculation, on the other hand, is buying something hoping a bigger fool comes along and pays more for it, regardless of underlying value.
A good company’s value can only go so low. If a business has produced $100 million in net profit every year for the past six years, has $200 million in cash, and has zero debt, it’s value is unlikely to drop below a few hundred million dollars. Otherwise, another company will come in and pay more than market value to buy the whole company.
If you buy that company’s stock at a value per share that represents a total market value of $200 million, you have little downside risk. You are buying shares at a value equal to its cash holdings. Any value from the earnings of the business are essentially free to you at that price.
This is the general idea of value investing, the investment approach Warren Buffett has implemented to become one of the richest people in the world.
It’s tempting to speculate, however. If the price of an asset shoots up, we’re wired to think it must keep going up.
The truth is that risk is likely higher at the inflated price. It’s easy for a business with zero profit and $10 million sales shoots up to $1 billion market cap to drop by 50 to 90%. There’s little underlying value to stop the decline.
This is the risk of speculation. You may have high upside potential, but you also have high downside risk. You could lose nearly all of every dollar you put in.
This is what Graham indicated when he said an investment must require safety of principal. Buffett has said the first rule of investing is to not lose money. The second rule of investing, according to Buffett, is to see rule number one.
To get our money to work for us, we must not lose a significant portion of it speculating.
Invest only in assets with limited downside risk. Investing in highly inflated assets with market values detached from underlying values is a bad idea.