Speculation vs. Investment

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We’ve seen our fair share of booms and busts in Alberta. Some people speculate on rising prices in the booms and make fistfuls of money. Some people crash and burn during the busts. In many cases, these are the same people.

And then there are the investors whose portfolios sustain a healthy cashflow throughout the seasons.

What makes the difference? Is it just luck of the draw? Or is there a fundamental distinction between a portfolio that can weather the storm and the portfolios that collapse under pressure?

A sound investment portfolio is engineered to mitigate risk. This means using systematic criteria to select productive assets in strong markets. It means using systematic management to maximize revenues, minimize expenses, and pack reserves to carry through a lean season. It means using financial leverage only in proportions appropriate to the portfolio’s cashflow. And it means keeping the exit strategies flexible so that multiple options are available when it comes time for harvest.

The harvest metaphor is a bit melodramatic, but it’s an apt comparison if you think about it. There are a million things that can go wrong with an agricultural crop. And if you know the risks, you can design your farm to mitigate them as far as possible. There are different philosophies. Some use chemicals, some use permaculture, but every farmer has a system.

Unlike a farmer, the speculator has a high tolerance for risk. There is a significant risk of losing most or all of the original amount invested. But for the speculator, that risk is more than offset by the chance for a huge gain in the short term.

The investor is about creating value and building assets over time. We create value in real estate by improving properties and operations and increasing rental income. We mitigate risk by buying smart, managing with dilligence, comprehensive insurance, and careful use of financial leverage. We design each asset with healthy cashflow to mitigate against risks like vacancy and interest rates.

And as long as our cashflow substantially exceeds our operational and debt-servicing outlays, we are never forced into a defensive position where we have to sell a property into a bad market in order to avoid default. Prudent investors are not fazed by the short-term ups and downs of property values. Through booms and busts, they harvest their cashflow dividends and can afford to wait until the time is right to choose their exit on their own terms.

Yes, you can speculate and sometimes hit the mark. And speculation has it’s place. Sometimes speculative opportunities with unpredictable outcomes produce dramatic upsides. But let’s be clear. Speculation and investment are not the same. If your pockets are deep enough to risk a loss, speculation can be an exciting and sometimes lucrative pastime. If you are looking for consistent and dependable wealth creation, you may prefer to graze in more predictable pastures.

 

 

NEXT ARTICLE 〉 Mitigating Risk – Know your hazards and look before you leap.