Investment versus speculation
Benjamin Graham's test for what counts as investing, and his two kinds of investor.
FinanceGraham ch. 1About 4 min: 2 reading, 2 practiceUpdated
General education, not financial advice.
- State Graham's definition of an investment operation
- Name the three ways speculation becomes unintelligent
- Tell Graham's defensive investor from his enterprising one
The Intelligent Investor: Benjamin Graham's ideas: lesson 1 of 24
- Graham ch. 1
- Investment versus speculation 4 min
- Graham ch. 2
- Inflation and the investor 4 min
- Graham ch. 3
- A century of market history 5 min
- Graham ch. 4
- The defensive investor's portfolio 4 min
- Graham ch. 5
- Defensive investors and stocks 4 min
- Graham ch. 6
- What the enterprising investor avoids 4 min
- Graham ch. 7
- What the enterprising investor does 5 min
- Graham ch. 8
- Mr. Market 5 min
- Living with fluctuations 5 min
- Graham ch. 9
- Investing in funds 5 min
- Graham ch. 10
- The investor and his advisers 4 min
- Graham ch. 11
- Security analysis for the lay investor 4 min
- Graham ch. 12
- Per-share earnings and their traps 4 min
- Graham ch. 13
- Comparing four companies 4 min
- Graham ch. 14
- The defensive investor's screen 4 min
- Graham ch. 15
- The enterprising investor's screen 7 min
- Graham ch. 16
- Convertibles and warrants 6 min
- Graham ch. 17
- Four extreme case histories 7 min
- Graham ch. 18
- Eight pairs of companies 7 min
- Graham ch. 19
- Shareholders, managements and dividends 5 min
- Graham ch. 20
- Margin of safety (1): the idea 5 min
- Margin of safety (2): in practice 7 min
- Graham appendix 1
- The superinvestors of Graham-and-Doddsville 6 min
- Graham postscript
- Graham today 7 min
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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), Introduction and chapter 1, "Investment versus Speculation"
What it is
Benjamin Graham (1894–1976) taught investing at Columbia and wrote The Intelligent Investor (first edition 1949, last revised 1973). His definition, first set out in Security Analysis (1934), is the backbone of the book:
An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.
Anything that fails those tests is speculation. Jason Zweig, in his 2003 commentary, breaks it into three parts. An investment needs all three:
- Thorough analysis of the business before you buy.
- Safety of principal: deliberate protection against serious loss.
- An adequate return: reasonable, not extraordinary.
Graham doesn't say speculation is wrong. He says it is unintelligent when you:
- speculate while thinking you are investing;
- speculate seriously without the knowledge and skill for it;
- risk more than you can afford to lose.
He counts borrowing to buy shares ("buying on margin") as speculation, and suggests that anyone who wants to speculate keep a small, separate fund for it, and never mix it with investments.
Quick check
Tap an answer to check it.
According to Graham, an investment operation must offer…
- Graham asks only for an adequate return
- That is a hope, not an analysis
Show answer
safety of principal and an adequate return, after thorough analysis. All three parts: analysis, safety, adequate return.
Why it matters
Graham's two kinds of investor are defined by how much work you will put in, not by how much risk you like:
- The defensive (passive) investor aims first to avoid serious mistakes and losses, and second to be free of effort and frequent decisions.
- The enterprising (active) investor is willing to spend real time and care choosing securities that are sound and better than average.
Most of the book is about which you are, and what each should do.
Worked example
Two people buy shares in the same company.
- Ana reads the company's reports, estimates what the business earns and owns, pays a price that leaves room for error, and expects a reasonable return. By Graham's test, she is investing.
- Ben buys because the price has risen fast for three weeks and a friend says it will keep going. He has borrowed half the money. By Graham's test, he is speculating, and the borrowing makes it more dangerous.
Same company, same day: what makes it investing or speculating is the process, not the thing bought.
Common mistake
Calling anyone who buys shares an "investor". Graham complained that newspapers used the word for everyone in the market, even people making emotional short-term bets. The word should describe how you decide, not what you own.
Key terms
- investment operation
- Graham: one that, on thorough analysis, promises safety of principal and an adequate return
- speculation
- any operation that fails Graham's test
- defensive investor
- aims to avoid serious losses and wants freedom from effort
- enterprising investor
- willing to put in time and care to find better-than-average opportunities
- margin
- buying with borrowed money; Graham counts it as speculation
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| investment operation | Graham: one that, on thorough analysis, promises safety of principal and an adequate return |
| speculation | any operation that fails Graham's test |
| defensive investor | aims to avoid serious losses and wants freedom from effort |
| enterprising investor | willing to put in time and care to find better-than-average opportunities |
| margin | buying with borrowed money; Graham counts it as speculation |
Practice
Sort it
Investing or speculating, by Graham's test?
Buying after studying a company's results and paying a price with room for error
Analysis, safety and a reasonable return.Show answer
Investing. Analysis, safety and a reasonable return.
Buying a "hot" new share issue because everyone is talking about it
No analysis; Graham names hot issues specifically.Show answer
Speculating. No analysis; Graham names hot issues specifically.
Borrowing from a broker to buy more shares
Graham counts buying on margin as speculation.Show answer
Speculating. Graham counts buying on margin as speculation.
Keeping 5% in a separate "fun" account, knowing it may be lost
Speculating knowingly, kept apart, as Graham allows.Show answer
Speculating. Speculating knowingly, kept apart, as Graham allows.
Buying shares because the price rose every day this month
Price trend is not analysis.Show answer
Speculating. Price trend is not analysis.
Quick quiz
Tap an answer to check it.
What decides whether you are a defensive or an enterprising investor, in Graham's view?
- Graham ties it to effort, not appetite for risk
Show answer
How much time and effort you are willing to put in. The enterprising investor is defined by willingness to devote time and care.
Graham's advice for someone who wants to speculate:
- He allows it, with limits
Show answer
Use only a small, separate fund, and never mix it with investments. Speculate knowingly, with money you can afford to lose, kept apart.
In short
- Investment = thorough analysis + safety of principal + adequate return.
- Speculation isn't wrong in itself; it is unintelligent when mistaken for investing, done without skill, or done with money you can't afford to lose.
- Defensive investor: avoid serious losses, minimise effort. Enterprising: put in time and care.
- What you buy doesn't decide it; how you decide does.
Mastery check
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Check yourself
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Name the three parts of Graham's definition of an investment.
Show answer
Thorough analysis, safety of principal, and an adequate return.
Is buying shares with borrowed money investing or speculating, for Graham?
Show answer
Speculating.
What separates Graham's two kinds of investor?
Show answer
The time and effort they are willing to put in, not their appetite for risk.
Further reading
- Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), Introduction and chapter 1.
- Before this path: The Gotrocks family and the rest of the Bogle path on this site.
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