Investing vs. Speculating

As many investors discover, mapping out an investment plan is the easy part. Sticking with that plan is what separates investors from speculators. To make the most of your investment opportunities, allow your lifestyle to dictate your investment approach—not stock market gyrations. Your goals are what count, so keep them firmly in mind when you make financial decisions.

Many investors use a consistent, long-term strategy to build a more secure financial future through steady purchases of well-diversified investments.

Speculators and market timers are usually less concerned about consistency. They may switch investment philosophies on an emotional whim, sometimes treating their investments more like play money than the serious money needed for future security.

Most people would probably say they are investors, but the question is not so easily answered. During a bull market, it can be relatively easy to be a long-term investor. However, when the stock market starts gyrating, investors' mettle can be tested—revealing many closet speculators.

For example, according to numbers compiled by the Investment Company Institute, a mutual fund research firm, investors pulled $11.7 billion out of mutual funds during the August 1998 market downturn. When the stock market rebounded in September 1998, investors reversed course, pouring $6.5 billion back into the funds. This kind of emotional response to short-term market fluctuation is just one example of speculative behavior.

Market timers follow a fairly predictable cycle. When prices seem low relative to historical norms, they buy. When an investment's value seems to peak, they sell. This cycle is repeated with the next "hot tip."

In theory, market timing seems fairly rational, but in practice it rarely works. Even the most sophisticated investors, with years of experience and the best analytical tools, cannot predict the whims of the financial markets. What's more, market timers are often misled by emotional factors such as greed or fear. Many end up buying at the tail end of a market rally or selling in a panic at a loss.

As shown in the chart, a market timer who missed the stock market's 10 best months over the last 30 years had a 30-year return only a little above that of Treasury bills. An investor who consistently invested in and held on to stocks over this same period earned over twice as much.

The difficulty of timing the markets is complicated by the fact that most market rallies occur in brief spurts. Market timers waiting for the right opportunity to buy or sell risk being out of the market during these sudden market changes.

To benefit from market timing, you must accurately predict the future, not once, but twice. First you must correctly determine when to sell. Second, you must accurately determine when to get back in. Because falling markets can rise steeply within days, your timing must be nearly perfect.

As many investors discover, mapping out an investment plan is the easy part. Sticking with that plan is what separates investors from speculators and market timers.

To avoid falling into the speculator's trap, focus on the term "individual" before making any investment decision. Your individual long-term goals and your individual financial circumstances—not the daily gyrations of the stock market—should govern your decision.

By focusing on your individual needs and sticking to your investment plan, you could actually benefit from the stock market's gyrations. For example, a good long-term investment strategy generally includes investing a set amount at regular intervals. If you maintain this schedule during a market dip, you may be purchasing some strong stocks at clearance-sale prices.

Of course, changing your investments during a gyrating market is not always speculating. It can be the mark of an astute investor if the reasons for your changes are consistent with your individual long-term goals.

Instead of market timing, try lifestyle timing. Look at your own investment portfolio and compare it to your long- and short-term goals.

Do you need to withdraw money within the next year or so to begin financing your retirement or to make some other lifestyle change? If so, you might want to reduce your percentage of stock investments.

What about your long-term goals? Short-term market gyrations will probably not significantly affect your long-term plans, and you would be wise to stick with your current strategy.

To make the most of your investment opportunities, allow your lifestyle (not stock market gyrations) to dictate your investment approach. And in following your investment strategy, use disciplined, systematic investing—like dollar cost averaging.

Dollar cost averaging is a policy by which the same dollar amount is placed in one or more common stocks or mutual funds at fixed, successive intervals, enabling you to average the purchase of your shares over a good many years. Assuming that each investment is for the same number of dollars, a greater number of shares are purchased when the price is low and fewer when the price is high. So you may get a satisfactory average price, instead of buying all the shares at the high levels of the market.

Over the long run, dollar cost averaging helps market fluctuations work for you, not against you. Because you buy more shares when prices are lower, and fewer shares when prices are higher, the average cost of your total accumulated shares in an investment increasing in value over time is below the average market price for all of the shares you purchased.

Disciplined, systematic investing does not promise a profit or protect you from a loss, but it does reduce the odds of you putting too much money into an investment when prices are high, and it also removes the emotional factor from your investment strategy.

Since a dollar cost averaging plan involves continuous investment in securities regardless of fluctuating price levels of such securities, the investor should consider his/her financial ability to continue purchases through periods of low price levels.

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