Information > Financial Terms > This page

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

In a general sense, any employment of capital in expectation of gain, whether in a business, farm, urban real estate, bonds, stocks, merchandise, education, etc.  In its more specific use in the field of securities (bonds, stocks), investment is contrasted to speculation in that investment is primarily for income, whereas speculation is primarily for capital gains; investment is for holding, whereas speculation is for turnover; investment is for the long term whereas speculation is for the short term.

These distinctions, however, are not fundamental.  Investment may be motivated by both types of gain-income and capital gain.  Investment rationally should involve turnover whenever the objectives of an investing program have changed or particular selections have reached their full potential or are no longer suitable for particular investing requirements.  Speculation may involve long terms of holding, e.g., cyclical or secular speculation.

The basic distinction between investment and speculation has been pointed out by Sauvain.  It is in the degree of assumption of investing risks.  An investment is a commitment in which the investing risks are minimized, whereas speculation is the aggressive assumption of risks in anticipation of substantial profits in consideration therefor.  the crucial problem in investing, however, is that no one type of investment is perfect relative to all the basic risks in investing.  Thus when an outstanding security analyst writes that "savings bonds are the safest investment, he is referring to the fact that such bonds are unquestionably highest quality from the stand-point of financial risk (the risk that the obligor might not pay) and interest rate risk (since savings bonds are nontransferable, i.e., nonmarketable, they are immune from the risk of open market depreciation in the event interest rates and yields on high-grade bonds should rise).  Savings bonds, however, like other fixed-income and fixed-principal investments, are vulnerable to purchasing power risk (the risk of shrinkage in purchasing power should the price level and cost of living rise).  Highest-grade marketable bonds are safest investments from the standpoint of financial risk, but are vulnerable to interest rate risk and purchasing power risk, i.e., speculative from the latter standpoints.  Common stocks are varying speculations from the standpoint of financial risk but are defensive from the standpoints of interest risk and purchasing power risk (assuming successful selection as price inflation hedges).

A highest-grade bond, an investment from the standpoint of financial risk, may be successful speculation in interest rate and purchasing power if timed properly, e.g., bought before a drop in interest rates from high levels or before a period of general price deflation.  Instead of dropping, however, interest rates might continue rising; instead of price deflation, further price inflation might ensue.  These are the risks that the speculator would assume in anticipation that the hoped for trends would develop.

For maximum minimization of investing risks, an investment program must be a diversified selection.  the usual solution for a sufficiently large principal is to cover income requirements by a layer of most defensive securities (highest quality from the standpoint of financial risk), which would usually be highest-grade bonds; then add a layer of highest-quality common stocks (from the standpoints of interest rate risk and purchasing power risk).  A speculation, by contrast, may ignore diversification and concentrate aggressively in a particular category of securities.  Thus an all-common stock portfolio is speculative in varying degrees from the standpoint of financial risk, and an investor with such a portfolio must be prepared to stand the risk of adverse fluctuation in earning power, dividends, and market value for particular common stock selections.  On the average, common stocks will normally fluctuate in a wider amplitude relative to financial risk than high-grade bonds will relative to interest rate risk.  A purely defensive investor, requiring highest stability of investment income and/or value of principal, would not find such a portfolio appropriate.

The determination of requirements for the particular circumstances of the investor concerned places the emphasis properly on the subjective in investment analysis.  Each investor, whether individual or institutional, will have varying circumstances as to supply of funds available for investment, requirements for stability of principal and/or investment income, and objectives for the investment program.  A first step in analysis should be to diagnose such requirements.  Prognosis of a suitable investment program should then logically follow.  Without such analysis, investors would be investing blindly and at random.  Individuals particularly have been prone to such random investing without proper planning, flitting from one investing fad to another without consideration of whether particular media are suitable for circumstances and objectives.  Educational programs of such sources as the New York Stock Exchange are educating individual investors to increase rationality in investing decisions.  By placing emphasis on the prerequisites to investing in securities - adequate personal savings, cash reserves for emergencies, adequate personal savings, cash reserves for emergencies, adequate insurance, and normal provision for home ownership - and stressing the importance of defining investing objectives - fund for education of children, to purchase an interest in a business, for estate building, for retirement, etc. - such programs bring about more rational investing and investment results.

FORMULA PLANS AND DOLLAR AVERAGING have been particularly promoted as devices to circumvent the problem of price timing and fluctuation and to profit with a minimum of overextended exposure to price risk.  There is no unbeatable formula, however, eliminating the necessity for exercise of judgment in initial selection and subsequent timing of changes.

Some Investing Guides.

The following general rules are considered to have wide applicability.

  1. Have an investing plan adapted to your circumstances and requirements.  Do not invest blindly.  Have some objective in mind or outlined in writing.

An ideal investing plan is one closely correlated to available excess income over living expenses, tax bracket, and family reserves.  In general, three investing preferences are prevalent:  emphasis on stability of principal, with least exposure to the basic investing risks; emphasis on income, consistent with reasonable stability of principal; and emphasis on capital appreciation, with income secondary and capital gains stressed as most important in consideration of increased risks assumed (so-called businessmen's investments).

Diversification should be a guiding principle in all well-constructed defensive investing plans relative to the basic investing risks.  Intensive, nondiversified investment is riskier but often deliberately characteristic of aggressive plans emphasizing capital appreciation.  Diversification may be executed as to total commitment in defensive securities as against aggressive securities relative to the basic investing risks; total commitment in any one industry; or total commitment in any one security.

  1. Review and revise your holdings periodically.  No investment, even the most defensive, is absolutely safe relative to the basic investing risks.  There is no bond or share of stock in existence which should be "locked up and forgotten."
  2. Devote attention to your investments.  If you do not have either the time or qualifications to do so, place your investing affairs in the hands of a competent investment adviser.  If your portfolio is not large enough to justify this expense, instead of selecting individual securities yourself, invest in INVESTMENT COMPANY shares, which is a means of delegating the problems of selection, turnover, and diversification to professional management.  There are pros and cons to open end (mutual fund) shares and closed end investment company shares.


Back to Information