Speculation and Investment

I

A CANDIDATE for a position in the statistical department of a security house, when asked to define the difference between stocks and bonds, replied with confidence that stocks were speculative while bonds were conservative investments. Needless to say, he was not employed. Yet his answer was only a naïve expression of opinions quite generally held.

To ‘ speculate,’as defined by the Standard Dictionary, is ‘to make an investment involving a risk, but with hope of gain.’ No definition is provided for making an investment, involving a risk but without hope of gain.

Many investors regard a clearly defined opportunity to enhance the principal value of their investments as a temptation against which they should turn their backs and close their ears. As a consequence, they are led to regard the act of renouncing all likelihood of capital gain as a virtue and of itself an assurance that they are avoiding all traces of speculation.

This accounts in part for the popularity of bonds as conservative investments. Investors have been encouraged by their legal and financial advisors to believe that all risk of loss has been removed from a bond issued by a company of the highest credit standing, through ironclad, trial-tested mortgage clauses, and that therefore it is conservative to invest in such bonds at prices that practically preclude any possibility of enhancing the values in their capital account. The less the possibility of profit, the more conservative the investment — the more conservative the investment, the less the possibility of profit. Thus runs the cycle of argument which they are expected to accept as self-evident, requiring no statistical support.

To the extent that law and language are competent to remove risks from mortgage bonds, they may have been removed. But the chief risk connected with the long-term holding of bonds or mortgages has not been removed from a majority of issues. (The minority, which contain suitable conversionprivileges, are exempt from the principal investment risks, as will be shown later on in this article.) The chief risk lies in the field of economics, beyond the reach of mortgage clauses to control. It lies, on the one hand, in the nature of the dollar, and, on the other hand, in long-term changes in the general level of interest rates, and consequently in the juices at which bonds are bought and sold.

In my studies recently published under the title Common Stocks as Long Term Investments, considerable space is given to the elements of risk inherent in a majority of bonds and mortgages, but for the purposes of this article the following examples, bereft of their technicalities, will suffice.

Among the most conservative bond issues which could have been purchased in April 1902, were Atchison, Topeka and Santa Fe General 4 per cent bonds, due 1995, and New York Central and Hudson River Railroad 3½ per cent bonds, due 1997. Let us assume that a conservative investor purchased one each of these bonds in that month. Let us further assume that he was forced to realize on them in July 1920 because of heavy payments which he had to meet in that month. His loss in dollars would have been as follows: —

This loss was due to no change in the credit position of the issuing companies, but was entirely due to a change in the general level of interest rates, which had risen almost continuously during the period named, so that bonds yielding a low rate could not maintain their principal value in competition with newer issues which were placed on the market at a higher rate.

The per cent of the purchase price lost was, for the Atchison 4’s, 31 per cent and, for the N. Y. Central 3½’s, 42.9 per cent. But this was not the whole loss sustained by the investor, for during the period from 1902 to 1920 the general level of prices had risen almost constantly, so that in each succeeding year a dollar became less effective in providing the necessaries of life. According to figures prepared by the U. S. Department of Labor, the dollar in 1920 had only 37 per cent of the purchasing power of the dollar of 1902. So our investor had not only lost, dollars, but had further sustained a loss through the shrinkage in purchasing power of the dollars which remained to him. Taking his two forms of loss together, he would have lost over 74 per cent of the purchasing power of the principal of his investment in Atchison bonds and over 78 per cent of the purchasing power of his investment in New York Central bonds. And none of this rather extreme loss would have been due to any impairment in the credit position of either of these companies.

These illustrations focus attention on two elements of risk that exist even in the highest grade of bonds in addition to the element which is given most prominence by a majority of those who offer bonds for sale: (1) depreciation of the dollar; (2) a general increase in current interest rates.

The third element which exists in some degree in all bonds and is most frequently discussed is: (3) the changing credit position of the debtor company.

The credit position of a company is subject to change over a period of years, either through changes in management or policies, or through changes in the underlying price, wage, social, or industrial factors on which the prosperity of the company depends.

In the case of the two bonds cited, we have instances of heavy loss in principal value sustained by the holder of bonds of the highest character, due to an increase in the general interest rate and a coincident lowering of the purchasing power of the dollar. There was no weakening of the credit position of the issuing companies. These bonds have since recovered a part of their price loss due to a falling in the general interest rate since 1920, and have further regained a part of their lost principal value through an increase in the purchasing power of the dollar. But it may be many years before a holder of these bonds purchased in 1902 will recover the full purchasing power of the funds originally invested.

If, then, the purchaser of the two bonds cited was persuaded to accept the low annual return which they offered and to forgo any probability of gain in principal, on the ground that all risk of loss had been removed, he did not receive what he paid for. The risk still remained. We could not have classed him as a speculator, because his purchase did not coincide with the definition of speculation, but was rather the act for which no definition is given, that of making an investment involving a risk but without hope of gain.

II

The aim of investment, as opposed to speculation, is to eliminate risk, on the basis of a thorough understanding of the nature of the risks involved in different mediums through which funds may be profitably employed.

There are two ways in which this can be done, both of which presuppose a clear understanding of the fact that every investment, no matter what its character, is, by itself, subject to special hazards. The science of investment, like that of insurance, consists of appraising the character of unavoidable risks and of neutralizing them through combination.

The first method is through diversifying investments, where the relative risks of individual securities cannot be clearly defined, but where, in combination, the probability of gain for the whole fund invested equals or exceeds the probability of loss. The second method applies where the character of the risk is clearly definable, and may be neutralized by creating a balanced investment position. Informed, disinterested judgment is essential to each method, and the purchase of a single security cannot be wisely made except in its relation to the investor’s total resources, purposes, and commitments.

With regard to investments in common stocks, speculation may be reduced, and in the end eliminated, through diversification. Principal invested in the common stock of a single corporation is subject to the temporary hazard of hard times, and may be permanently lost as the result of a radical change in the arts or of poor corporate management. But changes in the arts or poor management have never permanently affected adversely all the leading companies in the principal essential industries. By spreading the risk through diversified holdings in such companies, it has been found that risks of this character are effectively eliminated through the application of the same principles which make the writing of fire and life insurance policies profitable. The law of averages has been found to favor such a diversified holding of common stocks.

It happens, however, that, while intelligent diversification in common stocks eliminates the special hazards relating to the holding of a single stock, diversification in bonds does not accomplish the same result, for the reason that all nonconvertible bonds are subject to the same hazards, which are therefore not reduced by increasing the number of different bonds held. This can be brought out clearly by comparing bonds with contracts for the future delivery of a commodity, instruments whose speculative character is quite generally understood, but whose investment attributes are not so well known. The comparison will serve two purposes. First, it may present a somewhat different picture of the bond to those who have thought of it only as a highly secured credit instrument. Second, it will serve to illustrate how. through the balancing of risks, a single transaction of a speculative character may be offset by another transaction, with the result that the two, in combination, cease to be speculative and become investments.

III

There are hardly two instruments which, at first glance, appear to be so entirely dissimilar in character as a contract for the future delivery of cotton and a high-grade first-mortgage railroad bond. The ‘Cotton Future, as it is usually termed, is distinctly an instrument of speculation. A large part of the business of the cotton exchange is speculative. The purchase of a contract for the future delivery of cotton by the average individual is not an investment, and can never be so regarded. Yet there are circumstances under which the purchase of a Cotton Future becomes an investment of the most conservative sort.

Bonds, on the other hand, constitute in current opinion the preëminent conservative investment security, and a majority of those who purchase bonds do so to avoid speculation. The greater volume of bonds now outstanding are held as long-term investments, and properly so. Yet there are circumstances under which the purchase of a long-term bond of the highest character can be regarded only as a speculation.

These two instruments, then, — the bond and the contract for the future delivery of cotton, — seem in the main totally dissimilar, and yet upon examination they are found to have certain points of striking similarity.

A bond, after all, is no more than a contract for the future delivery of dollars. A dollar is, by definition, a certain weight of a certain commodity of a certain grade. The commodity is gold; the grade is 9/10 fine; the weight is 25.8 grammes.

The coupons on a bond are a series of contracts for the future delivery of smaller numbers of dollars at regular intervals. The bond itself is a contract for the delivery of a much larger number of dollars at a single distant future date.

A cotton contract likewise calls for the future delivery of a commodity. The commodity is cotton; the grade is middling; the weight is 100 bales of 500 pounds each.

The weight and grade of the dollar and of the cotton bale are both established by governmental enactment.

If you buy a cotton contract or a bond and are in a position to secure fulfillment of the terms of each, you are entitled to receive exactly what the government has defined each to represent. Essentially they are quite similar, except in the length of time that they customarily run before becoming enforceable, and in the bulk and durability of the commodities involved. Both are frequently sold before they mature, upon terms influenced more by outside conditions than by changes in the credit position of those who have contracted to make the specified future deliveries. Cotton contracts are liquidated in part through the cancellation of one contract against another. Thus also are the greater number of bonds and other dollar contracts liquidated.

There is as much misunderstanding of cotton futures as there is of bonds. This results, from time to time, in agitation for prohibiting the dealing in contracts for the future delivery of cotton, on the ground that contracts are created for the future delivery of a far greater number of bales of cotton than exist. In this respect, however, they do not differ from bonds, for there are outstanding, in the form of bonds and other maturing obligations, contracts for the future delivery of a far greater number of dollars than exist. And yet the propriety of buying and selling bonds has never been questioned, and never should be. Under sound regulatory measures, there is no less economic need for a free market in cotton contracts than there is for a broad bond market.

IV

When a cotton mill buys contracts for the future delivery of cotton to offset other contracts into which it has entered for the future delivery of manufactured cotton goods, its investment in cotton futures is one of conservatism — an insurance against loss which might arise from being without cotton contracted to be delivered.

VOL. 136 — NO.4 E

When a trust company or an insurance company buys bonds, against its own promises to pay dollars at a future date, it is likewise acting in accordance with the highest principles of conservatism. It is insuring itself against loss which might arise from being without dollars it has contracted to deliver.

When, however, an individual, not engaged in the manufacture of cotton goods, nor having any commitments in terms of cotton, buys a contract for the future delivery of one hundred bales of cotton, he is speculating on the future value of cotton in terms of dollars. And similarly, to a greater extent than is usually believed, when an individual, not engaged in banking or insurance and having no present commitments to pay a fixed number of dollars at a future date, buys a bond which promises him only a certain number of future dollars, he is speculating, whether he realizes it or not, on the future value of dollars in terms of cotton (among other things), or rather on the exchange value of dollars in terms of those commodities and goods which he or his family may require — the cost of living.

The situation existing under these two forms of speculation may be expressed in terms familiar to the speculative markets as follows: an individual purchaser of Cotton Futures goes long of cotton and short of dollars; an individual purchaser of bonds goes long of dollars and short of the cost of living.

A careful appraisal of underlying conditions may justify either position from a speculative point of view. And if the personal situation of the holder of either bonds or cotton contracts is such that each offsets another hazard, either may be regarded as a pure investment or insurance against loss, but in the absence of such a balanced situation they are both speculative in nature.

Thus it has happened that an individual’s investment in bonds of the highest credit rating in 1902 has proved progressively an unfortunate speculation in terms of the cost of living throughout the intervening years, because each year, with but few exceptions, the dollar has lost in purchasing power.

True — if, as many believe (though some do not), the cost of living may be counted on, in the years ahead, continuously to fall, then the holders of bonds may expect to profit progressively at the expense of the issuing companies. It must not be overlooked, however, that long-term movements in the general price level constitute as much of a speculation for corporations issuing bonds as they do for bondholders. A long-term fall in commodity prices results for many heavily bonded corporations in an increasing difficulty to make adequate margins of profit out of which to meet interest payments and set aside reserves for the retirement of their bonds as they mature. As a consequence, our longest period of falling prices culminated in a period of high mortality among heavily bonded corporations (1893-1896). It is one thing for corporations to refund a bond issue when, through depreciating currency, the replacement value (in dollars) of the properties which are pledged as security is greater than their original cost, and quite another when conditions are reversed. Hence, if falling prices are to be expected, investors must exercise greater care in appraising the credit risk of bond-issuing corporations than has been needed in the past quarter-century.

A protracted falling in the general price level has been accompanied, in the past, by a reduction in the general level of interest rates. Such a movement in the future would be to the marked advantage of bondholders at the expense of the issuing corporations, as it would be accompanied by a rise in the price at which bonds could be sold on the open market. Thus an investor, buying a bond on a five to six per cent yield basis, might expect to make a handsome profit if he foresaw a fall in general interest rates justifying a future market for the bond on a yield basis of from three to four per cent. Such a tendency in the general interest level is not at present beyond reasonable expectation. In any event, its possibility has been foreseen by a majority of corporations which have floated bond issues in recent years. As a result of sound financial counsel, practically all recent issues contain a clause under which the company retains the right to redeem its bonds at a slight premium over par. This provision is wise from the point of view of the issuing company, as it serves to limit the speculative advantage which a holder of its bonds may obtain at the company’s expense, if underlying conditions turn definitely in favor of the holder and against the company. It serves, in the language of the Street, as a ‘stop-loss order,’ in favor of the company, in connection with the long-term speculation in general prices which the company enters into with the holders of its long-term bonds.

There are, however, comparatively few bonds containing a provision by which the holder may convert the bond into common stock, should future conditions tend definitely in favor of the company at the expense of the bondholder. In the absence of such provisions, the bondholder must suffer the full losses entailed in continuously rising prices accompanied by a rise in general interest rates. No ‘stop-loss order’ has been placed on his behalf.

The great market to-day for bonds, and the market in which speculation is eliminated, is to be found in savings banks, insurance companies, and other financial institutions. These institutions render services of extraordinary value to the community. Their business consists of creating dollar commitments. Their safest form of investment is consequently in bonds and other dollar obligations. It follows that there is a very great and, at present, a very rapidly expanding market for bonds of the highest credit standing, without conversion privileges — a market that it will be hard for bond-issuing corporations to satisfy.

Thus no present need exists for corporations to depart from their present practice of protecting themselves against too marked a future change in price level and general interest rates while giving their bondholders no equivalent protection. The greatest buyers of bonds already have such protection in the very nature of their business.

But individuals or estates whose investments are made with the happiness and comfort of families as their object, or educational and charitable institutions whose endowments are invested to assist in defraying operating expenses at whatever price level may prevail in future years, should ponder well the form of security in which their funds are invested, should carefully consider the effect of possible changes in fundamental conditions upon the relation of future income to future outgo. The only means by which such investors may avoid speculation is through the neutralization of unavoidable hazards, by diversification, and through establishing a true balance between the nature of their future commitments and the nature of their investment, holdings.