Superinvestor Seth Klarman has famously said that investments are assets that produce cash flow. If they don’t, they’re speculations. It’s a simple but astute observation that undercuts what many consumers consider investments — things like gold and handbags and baseball cards.
So what’s the logic behind Klarman’s quote? Investments are assets that provide goods or services that are valuable to someone and generate cash flow. An investment could be a profitable business or an ownership stake in such a business, like a stock. Good investments become more valuable over time because they increase their cash flow. Owners of these assets have a claim on that cash flow, so investors want to buy stock in them.
In contrast, speculations are assets that don’t produce cash flow. Their value is tied to whatever price people are willing to pay for them. Because they don’t produce cash, any potential profit from the asset depends, crucially, on getting someone else to pay a higher price than what you paid. It’s called the “greater fool” theory. (This isn’t to say that some people can’t make money in speculations, but rather that they’re not a solid basis for investment.)
Klarman’s advice: Buy investments, not speculations. For many investors, that means acquiring stocks of cash-flowing companies in the stock market. Using Klarman’s criterion, these three highly popular “investments” aren’t investments at all.
1. The fad of the moment
Shoes, handbags and baseball cards — to name just a few things — are the epitome of speculation. Consumers put money into these products thinking they’ll be worth more in a few years, and the producers are often only too happy to feed this fantasy with “limited edition” collections at marked-up prices.
Many consumer goods have had their place in the sun, such as Star Wars action figures, sports cards, Beanie Babies, Dutch tulips — speculations all. A few years later they’ve been forgotten as the next fad rises.
As with anything aesthetic, buy it because you like the art, the handbag or the action figure. Do not expect to sell it for more.
2. Your home
Nobody likes to hear that their single largest asset is a speculation, but that’s the case with a home you live in. A house or apartment produces no cash for its live-in owner. So like other speculations, the price of a house does not depend on its producing cash flow for the owner.
What about real estate as an investment? An owner-occupied house is different from a property that you own to generate rental income. By definition, a rental property is an investment, and potentially a good one, depending on the purchase price and how it’s managed. However, a “flip” house, where the buyer has the intent to quickly turn around and sell it, perhaps with some improvements, is a speculation. Yes, plenty of good returns can be built on speculations — but the asset itself is a speculation.
We all have to live somewhere; own a home because you like it, or because it makes better financial sense than renting. Don’t own a house just because you think you can sell it for more later.
3. Gold and other commodities
Gold investors love to say that the metal has real value, because it’s a hard asset, unlike paper money that can be created at will. But it’s just as much a speculation as your house and fads, because its value does not rely on it producing cash flow. Speculators are wagering on gold to rise in value so they can get more dollars when they sell it, not because the financial system will crumble and we’ll only have shiny metal to trade with. The same goes for other commodities, such as other precious metals, diamonds and agricultural goods. Include bitcoin in this bin.
If you like gold, buy stock in an investable company that mines it and generates cash from operations. If gold prices do rise, the company will have more upside than the commodity itself.