Separating speculators from buy-and-hold investors

This article appeared originally in Gulf News: link to original article

When signing up for a savings and investment plan, offered mainly by insurance companies, the sales representative does a risk profile assessment of the individual subscribing to it. Two key questions are always asked: 1. How long will the subscriber hold the portfolio for? 2. How likely is it for the subscriber to liquidate the portfolio when markets take a downturn?

Those two questions are not only important in evaluating one’s risk profile, but also in understanding whether their investment in stocks is short-term or long-term focused. This is crucial given the high liquidity and tradability in stock markets compared to other investment options like bonds, which increases the investor’s susceptibility to freak out and sell when stock prices take a dip.

For example, and before moving from physical to electronic share trading, the price of Union Coop’s stock used to barely budge from certain perceived levels of its worth. This changed when electronic share trading was allowed, which despite the volatility that it induced to the stock price, also ensured that its price today better captures true demand and supply for the stock.

Therefore, volatility in price and the direction that it takes should not matter, especially since the stock easily classifies as a blue-chip one. The classification is typically used for stocks of companies with years of well-established operations and good dividend payout.

That is befitting of a buy-and-hold strategy, which is more appropriate for long-term investors and those interested in improving their pensions. The buy-and-hold strategy is one of two broad categories for investing in stocks, with the other one being speculation.

Buy-and-hold is mid- to long-term focused, where the period of holding stocks is subject to the investor’s own research and analysis. Buy-and-hold warrants, at least theoretically, that stocks are bought based on the soundness of companies’ financials, their growth prospects, as well as any intrinsic value in their stocks. Unlike the case with blue-chip stocks, those factors are more relevant when looking into buying recently listed stocks.

The buy-and-hold strategy avails the investor from the need to constantly monitor stock prices, and hence also decreases the urgency to sell if prices drop. Time is better spent on the research that goes into building the portfolio and into timing the purchase of stocks, as a wrong timing could negatively affect the portfolio’s value despite the soundness of the stocks bought.

Summing it up, a buy-and-hold strategy must result in a portfolio with a mix of stocks that are bought at the right time, which safeguards the investor’s capital, and the payouts match long-term returns targeted by the investor.

Speculation, unlike buy-and-hold, is short-term focused and involves daily trading activity. Returns are made by riding stock market cycles and arbitrating price fluctuations. Such a strategy is not suitable for individual investors or investors keen on improving their pensions. Here’s why.

Speculation requires constant monitoring of markets where stocks are being traded. This could entail a round-the-clock market watch that would consume most hours in a day, which is not ideal for individual investors unless trading in stock markets is their bread-and-butter.

Also, and in order to maximise profits, higher capital is usually needed to speculate and make profits out of the small daily changes in prices of stocks. Otherwise, risks associated with speculation as an investment strategy cannot be justified.

Those risks include, for instance, uncontrollable events that could result in suspension of trading in the related company’s stock. Corruption scandals and resignation of chief officers are examples of such events.

There is also the risk of stock prices going in the opposite direction to that favoured by the speculator, who, lacking the capital to oppose it, could wipe out any previously made gains.

In conclusion, investors in stock markets can be grouped into two broad categories. Speculators tend to be interested in riding market cycles to maximise their daily gains before moving to other stocks or switching to other promising markets.

In contrast to buy-and-hold, speculation does not fit into retirement planning. If the right time and effort is allotted to researching companies and stocks, a buy-and-hold strategy should deliver adequate and sustainable long-term returns.

Moreover, paying attention to the mix of stocks and picking the right buying time allows a buy-and-hold portfolio to offer capital protection today … and capital appreciation in the future.

The last thought that I want to leave you with: How long can dividends be paid out without undermining the company’s growth prospects?