Committing money against a horizon
The syllabus defines investment, in the securities market, as the upfront commitment of a sum of money to earn returns on it during an investment horizon. The commitment comes after thorough analysis of the underlying security on three counts: its safety or risk, its income, and its growth potential. That definition is built to separate investing from two activities that look similar from the outside, trading and speculation.
Traders, and the three names they go by
A trader tries to earn the spread between the selling price and the buying price without any necessary change in the underlying value of the asset. What motivates the trader is a historical price pattern and the expectation that it will recur, not a directional bet based on incomplete information about the asset. The time horizon is therefore usually short.
The syllabus then hands out labels, and the exam expects you to match each to its definition.
The syllabus's own sample question fills two blanks: speculation is a short-term call made with leveraged funds, unlike investment, which is a long-term disciplined activity for creating wealth. Any option that pairs speculation with the long term, or investment with the short term, is wrong.
What makes value rise
Investment focuses on the potential of an asset's value to increase over a period. In the securities market that value rises in two ways: the asset generates higher cash flow without a proportionate increase in risk, or the risk attached to the asset falls without a proportionate decrease in cash flow. This is the difference that separates investors from traders. Traders profit from price patterns and price anomalies that get corrected within a period of up to 3 to 6 months, with no change in the fundamental value of the asset.
A pharmaceutical company wins approval for a new drug. An investor reasons that future cash flows have risen while risk has not risen in proportion, so the value of the share has gone up, and holds for years. A trader notices that the share has bounced off the same price level three times in the past year and buys expecting a fourth bounce within a few weeks. Both may make money. Only the first is investing.
Because it rests on value rather than pattern, investing is the more demanding task and needs a higher level of rigour in analysis. That analysis can sit at the level of a broad asset class or drill down into individual stocks, which is exactly the fork between the two investing styles.
Active investing
Active investing means identifying the specific security, or set of securities, to buy or sell. It calls for constant evaluation of every security in the portfolio so that the investor can sell what is priced above its intrinsic value and, when buying, find what is priced below it. Active strategies therefore take more effort and involve more transactions than passive ones. The active investor's objective is a rate of return above the return of the broader asset class.
Passive investing
Passive investing means holding a broad set of securities that fairly represents the asset class the investor wants. Typically it follows an indexing strategy: buy every security that is part of an index. The objective is to earn the rate of return the chosen asset class provides, no more. A passive investor does not decide which individual securities to buy or sell; the analysis stops at the level of the asset class.
| Active | Passive | |
|---|---|---|
| Decides on | Individual securities | The asset class only |
| Method | Buy below intrinsic value, sell above it, evaluate constantly | Hold everything in a representative index |
| Effort and transactions | More | Fewer |
| Return objective | Beat the asset class | Match the asset class |
- Investment is an upfront commitment of money to earn a return over a horizon, after thorough analysis of safety or risk, income and growth potential. It is distinct from trading and speculation.
- A trader earns the spread between selling and buying price without any necessary change in the asset's value, on the expectation that historical price patterns recur; horizon short. Speculators bet on short-term moves on a calculated guess, chartists rely on price patterns and charting, day traders complete the cycle in one day.
- An asset's value rises when cash flow grows without a proportionate rise in risk, or risk falls without a proportionate fall in cash flow. Traders instead profit from price anomalies that correct within roughly 3 to 6 months with no change in fundamental value.
- Active investing picks securities (buy below intrinsic value, sell above), takes more effort and more transactions, and aims to beat the asset class. Passive investing holds a broad set representing the asset class, typically every security in an index, and aims to earn the asset class return.