Introduction to Investment and Speculation

It is well nigh impossible to define the term ‘speculation’ with any precision. Investment and
speculation are somewhat different and yet similar because speculation requires an investment
and investments are at least somewhat speculative. Investment usually involves putting money
into an asset which is not necessarily marketable in the short run in order to enjoy a series of
returns the investment is expected to yield. On the other hand, speculation is usually a more
short-run phenomenon. (Reilly, Brown, Strong, and Wickramanayake, 2012)
Criteria used to distinguish Investment and Speculation
Risk Analysis and Risk appetite; Investor will generally rely on the fundamental analysis of
financials and other factors which can affect the price of the asset class and their decision to
invest in particular asset is based upon certain fundamental values associated with the asset.
Investors do have long term risk and return perspective. Speculators do take higher risk for
expects higher returns in short period. Gambler risk entire capital on bet and relay mainly on
luck. They are the highest risk takers and ready to lose original investment also. (Sharpe,
Alexander, and Bailey, 2009)
Price of the asset: Investor does not look at the price of the asset rather it looks at the asset itself
to determine the decision to allocate some money now to get some money back later on. Investor
does not get influenced by daily fluctuations of the asset price, because his/her allocation of
money decision is based on the intrinsic value of the assets rather than price. Speculators look at
the price of the asset to allocate the money and they do get influenced by the daily fluctuations of
the price of the assets, aim of the speculator is to get some quick reward. Gambling is based upon
odds and bets are placed only on assumptions. (Reilly, Brown, Strong, and Wickramanayake,
2012)
Time Horizon: Investors allocate money for a particular asset for longer period while
speculators allocate money for shorter period, on the other hand gambler place bet for immediate
gain. (Reilly, Brown, Strong, and Wickramanayake, 2012)
Leverages: An investor allocates money from its own resources for investment while and
speculators may also rely on borrowed money to allocate. This is applicable mainly to assets
belongs to equity market. Gambler generally allocates their own money and place bet for
entertainment or fun. (Reilly, Brown, Strong, and Wickramanayake, 2012)

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Whether Investment and Speculation can be incorporate with the same Security
It is not possible since the truth of the matter is every activity we perform involves speculation
and the individual comes in the open and uses its judgment to forecast the future course of events
and act accordingly on it. This peculiar psychology makes many investors avoid certain stocks or
bonds due to its unforeseen possibilities making investors judge safety by the yield and stability
offered. If a security is paying beyond a certain threshold, it is classed as ‘speculative’ and is not
for them. One should note that all Investments are Speculation but all Speculations are not
necessarily investments. The objective of both is to earn profits, only the method involves a
difference. There is nothing correct or incorrect in the approach, but it depends on the long-term
objective of the individual and the quantum of risk they are willing to bear.
Comparisons between Traditional and Modern Approaches to Security Analysis, to
Portfolio Management
Traditional portfolio analysis has been of a very subjective nature but it has provided success
to some persons who have made their investments by making analysis of individual securities
through evaluation of return and risk conditions in each security.
In fact, the investor has been able to get the maximum return at the minimum risk or achieve his
return position at that indifferent curve which states his risk condition. The normal method of
calculating the return on an individual security was by finding out the amount of dividends that
have been given by the company, the price earnings ratios, the common holding period and by an
estimation of the market value of the shares.
Traditional theory was based on the fact that risk could be measured on each individual security
through the process of finding out the standard deviation and that security should be chosen
where the deviation was the lowest. Greater variability and higher deviations showed more risk
than those securities which had lower variation. (Sharpe, Alexander, and Bailey, 2009)
The modern portfolio approaches believes in the maximization of return through a
combination of securities. The modern portfolio theory discusses the relationship between
different securities and then draws inter-relationships of risks between them.
It is not necessary to achieve success, only by trying to get all securities of minimum risk. The
theory states that by combining a security of low risk with another security of high risk, success
can be achieved by an investor in making a choice of investment outlets. (Sharpe, Alexander, and
Bailey, 2009)

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The modern theory is of the view that by diversification risk can be reduced. Diversification can
be made by the investor either by having a large number of shares of companies in different
regions, in different industries, or those producing different types of product lines.
Thus, traditional theory and modern theory are both framed under the constraints of risk and
return, the former analyzing individual securities and the latter believing in the perspective of
combination of securities. (Sharpe, Alexander, and Bailey, 2009)
Valuation of Bonds Harder or Easier Than the Valuation of Common Stock
In finance, stocks are often referred to as equity securities, because they make the holder part
owner of the corporation, or provide an equity stake. Bonds, on the other hand, are lending
instruments. The company owes the bondholder a specific sum of money, but the bonds do not
entitle the investor to have a say in how the company is run. Furthermore, the bondholder will
not be paid more than what he is owed if the company does unexpectedly well. Due to these
reasons, bonds are generally easier to value than stocks, though exceptions exist.
A share of common stock is more difficult to value in practice than a bond because for common
stock promised cash flows are not known in advance. (Elton, 2014) Common stock is forever
because it has no maturity. It isn't easy to observe the rate of return that the market requires
stockholder part owner so you share the profits, no limit on how much money you can make but
you also may not make any money. (Elton, 2014)
Shares of Stock are a lower priority claim than bonds, and are sometimes called residual claims.
Both are of different entities but commonly available in market. Bonds value depends on the
companies attributes, like goodwill, performance, debits and credits, profit and loss and overall
market shares, hence one can predict that today market will rise for particular companies bonds
or will go down. Whereas for common stock we can’t predict since various factors involved.
Example take a common stock items like cotton hand gloves having different manufactures and
lot of suppliers in market, price will change due to market competition between them and place
of supply, raw material used, local taxes, import and export duties places a crucial role in
determining the price. (Elton, 2014)
Popular Stock Valuation Methods
Essentially, stock valuation is a method of determining the intrinsic value (or theoretical value)
of a stock. The importance of valuing stocks evolves from the fact that the intrinsic value of a
stock is not attached to its current price.

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Below, we will briefly discuss the most popular methods of stock valuation.
Dividend Discount Model (DDM)
The dividend discount model is one of the basic techniques of absolute stock valuation. The
DDM is based on the assumption that the company’s dividends represent the company’s cash
flow to its shareholders. Essentially, the model states that the intrinsic value of the company’s
stock price equals the present value of the company’s future dividends. Note that the dividend
discount model is applicable only if a company distributes dividends regularly and the
distribution is stable. (Smart, Gitman, and Joehnk, 2013)
Discounted Cash Flow Model (DCF)
The discounted cash flow model is another popular method of absolute stock valuation. Under
the DCF approach, the intrinsic value of a stock is calculated by discounting the company’s free
cash flows to its present value. The main advantage of the DCF model is that it does not require
any assumptions regarding the distribution of dividends. Thus, it is suitable for companies with
unknown or unpredictable dividend distribution. However, the DCF model is sophisticated from
a technical perspective. (Smart, Gitman, and Joehnk, 2013)
Comparable Companies Analysis
The comparable analysis is an example of relative stock valuation. Instead of determining the
intrinsic value of a stock using the company’s fundamentals, the comparable approach aims to
derive a stock’s theoretical price using the price multiples of similar companies. The most
commonly used multiples include the price-to-earnings (P/E), price-to-book (P/B), and enterprise
value-to-EBITDA (EV/EBITDA). The comparable companies’ analysis method is one of the
simplest from a technical perspective. However, the most challenging part is the determination of
truly comparable companies. (Smart, Gitman, and Joehnk, 2013)

References

Brown G. R and Matysiak G. A. (2000), Real estate investment: a capital market approach.
Harlow: Financial Times Prentice Hall,

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Elton E. J., (2014) Modern portfolio theory and investment analysis, Ninth edition. Hoboken, NJ:
John Wiley & Sons, Inc, 2014

Reilly F. K., Brown K. C., Strong R. A., and Wickramanayake J., (2012) Investments and
Portfolio management for Monash University, 1st ed. Melbourne

Smart S. B., Gitman L. J. , and Joehnk M. D., (2013) Fundamentals of investing, Twelfth
Edition., vol. Pearson series in finance. Boston: Pearson

Sharpe W. F., Alexander G. J., and Bailey J. V., (2009) ‘Investment Management in Investments,
6th ed., Upper Saddler River, NJ: Prentice Hall

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