…and not a drop to drink? Does lower liquidity flush out speculators?

Benjamin Graham made a distinction between ‘investors’ and ‘speculators.’ In essence, investors are those who hold the asset as if they actually want to own it; they think the returns they will receive from dividends or coupons, and from the earnings growth of a company or the return of principal on a bond, are attractive in their own right.

Speculators on the other hand are those who buy an asset mainly with a view to selling it to someone else.

In most parts of financial markets either the distinction between the two isn’t made, or speculation is treated as a dirty word. Speculators are viewed as gamblers, they play the ‘greater fool’ game or Keynes’ ‘beauty contest,’ and if they are successful, it was probably down to luck.

The reality is that you can make money through investment or speculation, or most likely, a combination of the two. But a recent piece from Goldman Sachs discussing the changing landscape for market liquidity reminded me of another quote from Graham, which gets to the heart of how much of a speculator you truly are:

“Ask yourself: If there was no market for these shares, would I be willing to have an investment in this company on these terms?”

The Goldman’s piece echoed arguments that have been made elsewhere that regulations have limited the ability of banks to offer immediate execution. Trades that could previously be done almost instantaneously because intermediaries would take on the risk while searching for the other side of the trade are now delayed until the eventual buyer/seller was found.

Steve Strongin, head of Global Investment Research at Goldman, echoed concerns expressed elsewhere:

“From an investor’s standpoint that is very uncomfortable because we live in a 24-hour news cycle, so information is flowing much faster, but your ability to execute trades is now much slower”

What would Graham have made of this? At the start of the twelfth chapter of Intelligent Investor he gives this piece of advice to investors:

“Don’t take a single year’s earnings seriously’”

The idea that investors should ignore even an entire year of profits information is completely at odds with the idea of the 24-hour news cycle. The world may indeed have changed. However, as investors with a value and behavioural bias, we in the Episode team would argue that much of the 24-hour news cycle isn’t ‘information’ at all, but noise. The fact that investors receive earnings data quarterly at most, but receive price data every second is indeed one of the reasons that we think fear, greed and myopia can creep in.

If genuine information comes out that harms the fundamentals of the company you are investing in, and it is picked up in rolling 24 hour news, then it is most likely already too late.

So does this mean that short term speculators will be hurt more by these dynamics? In a Bond Vigilantes post in 2012 Richard Woolnough noted that developments meant that it was likely that ‘transactions between genuine end investors’ had increased and that activity of many short term players had collapsed. Will it also make life harder for insider traders, front runners, and flash boys?

That remains to be seen, but there are more important questions we need to ask ourselves as longer term investors.

In the Goldman’s piece Steve Strongin also stated that while regulations arguably made the system less vulnerable to systemic banking crises, the resultant reduction in liquidity leaves us more vulnerable to market failures, namely a greater risk of crashes.

To what extent can these price crashes have a fundamental impact on the real economy? Has the fact that the share price has fallen damaged the inherent profitability of the company, or would a broader market crash damage future growth?

It is debatable, but it would seem that most short term volatility without an origin in the fundamentals such as the ‘flash crashes’ that have been experienced in recent years are more likely to represent opportunities for long term investors than sources of concern. There are still sufficient numbers of long term investors who are willing to step in when price moves are unjustified.

The other commonly raised concern is more practical: “What if I need to get my hands on the money right now? Can I get it in an emergency, especially if everyone else is running for the door?”. The events of 2008 showed this has always been a possible problem. The unexpected can always happen and portfolios should therefore always contain enough genuinely liquid assets (i.e. cash) to deal with them. However, if you ‘need’ your cash at the same time as everyone else it may be worth asking yourself again whether you are investing, or speculating.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.