Investment Versus Speculation

Imagine an orchard where, every season, fruit is harvested and sold for income. How much is the orchard worth?

One owner might say that the orchard is worth so many dollars—what it could be sold for. But another owner might say that the orchard is worth so many dollars per year; that is, it’s worth is expressed in the income it generates, not in it’s current market value. Ownership of such income-producing assets is what allows wealthy families to remain wealthy over generations.

Let’s define investment as the purchase of an asset that produces an income stream: dividends from stocks, interest from bonds, rents from real estate, fruit sales from orchards. Investments can potentially provide both income and capital gains.

In the case of stock and bond funds, reinvesting dividends in additional shares drives compound growth, which allows the value of your holding to grow at an exponential rate.

Accordingly, let’s define speculation as the purchase of an asset that doesn’t provide income. The payoff of owning such an asset would come when you sell it to a buyer willing to pay you more than your original purchase price (aka the Greater Fool Theory). Speculations can only provide capital gains, offering no opportunity for reinvestment and compounding. You can grow the size of your holding only by adding more out-of-pocket money.

There are certainly times when speculative assets produce handsome returns. But without producing income, they are hard to value and, as a result, are more volatile—that is, riskier. Your ability to sell at a profit is subject to the whims of future buyers.

There is an opportunity cost to owning a speculative asset—the loss of income you could have earned elsewhere. When real interest rates are relatively low or expected to decline, the opportunity cost is low and may be ignored. But when real interest rates are relatively high or expected to rise, the opportunity cost is higher, and becomes a more significant factor.

Gold is a good example of a speculation because it pays no interest. You hope that one day you can sell your gold for a profit but, in the interim, you receive nothing. Gold has value because people say it does.

Many people invest in gold as an inflation hedge. Unfortunately, gold is not a reliable inflation hedge. When the opportunity cost of owning gold is low, gold prices tend to correlate with rising inflation. But when the opportunity cost is higher, investors may swap gold for cash or bonds which offer income. The price of gold may decline just when you expect it to protect you.

One could argue that a speculative asset having a low correlation with stocks and bonds, added to your portfolio, could reduce its overall volatility, perhaps leading to better risk-adjusted returns. Admittedly, an allocation to a speculative asset for this reason might be justified, but in a modest range of 5-10%.

During a market downturn, however, reinvesting your portfolio’s income stream could help it recover more quickly, perhaps making it easier for you to stay the course. A speculative asset without an income stream would’t be of help in this regard.

What about growth stocks that pay no dividends? Are they an investment or a speculation? Perhaps we should regard “no dividends” as “deferred dividends.” The expectation is that such companies will grow into mature, profitable enterprises that will pay dividends in the future. Both Microsoft and Apple, for example, are now mature companies paying a dividend.

What about companies that buy back shares instead of paying a dividend? Fewer outstanding shares means each share claims a greater proportion of the company earnings and should see it’s market price rise. This is an alternate way for a company to return value to it’s shareholders without tax consequences. If you wish, you could sell a few appreciated shares and generate your own dividend to either spend or deploy elsewhere.

While buybacks are more tax-efficient than dividend distributions, they do have drawbacks:
There is no opportunity to reinvest internally-generated income.
Unlike dividend policies which companies strive (indeed are expected) to maintain, buybacks can be discontinued at any time.
If most or all of the shares purchased are subsequently granted as compensation to executives or employees, there is little or no reduction in outstanding shares, limiting the benefit.
And, ironically, companies seem prone to purchase shares during bull markets when prices are high—yet do few or no buybacks during bear markets when prices are low.

While I am grateful for companies that do buybacks to reduce the number of outstanding shares, I would rather have a dividend, pay the tax, and have cash in my pocket to reinvest or spend as I see fit.

I personally don’t own speculative assets like gold or cryptocurrency nor do I intend to purchase such assets. I prefer to own the stock of enterprises profiting from the sale of goods or services that people want or need to buy. I adhere to the belief that, in the long run, investing in a broad stock market index fund at low cost is likely to beat the returns from speculation.

The same might be said for bonds, real estate … and orchards.