Clarifying 'Speculation'

There's been a lot of Bogle talk lately regarding his bashing of specialty ETFs for being, among other things, tools for speculation. To oversimplify his view, he believes in proper asset allocation and holding cheap, broad-based mutual funds. He seems to label everything else as speculation.

This seemed to prompt a reader to post the following comment:

Hi Roger- a co-worker of mine continues to advocate that any forward looking market analysis is purely speculation and that the likes of Peter Bernstein, Bogle, Harry Browne, William Berntein, Mauldin, etc. advocate that forward looking analysis is rather challenging. attached is a link whereby even Barry Ritholtz admits the same.

I have read where you do not believe in broad based passive products and if I interpret your comments correctly do not like to look backward but attempt to look at te macro picture via a top down sector approach. Please clarify how this approach is not speculation?

I gave a short reply and reader Rhianni32 gave a more thoughtful reply. I wanted to delve into it a little more this morning.

A question I usually ask truly passive investors is whether they do any forward looking analysis in their investing -- this seemed to be obviously missing from the week-long discussion we had here recently about the Permanent Portfolio. The reader's comment goes all over the place, but the easy part is that a bunch of people "advocate that forward looking analysis is rather challenging." Investing is not a particularly easy endeavor. There are ways to make it a little easier on yourself, but I think most people can agree that it is challenging. Still, I would say that buying more stock funds after your equity portfolio has been cut in half (i.e. rebalancing) is also challenging.

As far as looking backward, the reader is not quite right. I describe what I do as taking how things usually work, combining that with what I think is going on now, and trying to make a forward looking analysis. No market participant can be correct with every decision, and knowing that ahead of time is one way to make things a little easier on yourself by not making big bets.

With regard to not preferring broad-based funds, I've written hundreds of posts about using individual stocks and specialty ETFs to manage very specific characteristics of the portfolio. I target things like cap size, style, country weights, sector weights, volatility and yield. It is in these decisions that the concept of risk adjusted returns comes into play. Being right about including one country and underweighting one sector can go a long way toward helping returns.

The reader asks how this is not speculation. Well, by Bogle's definition, it would be. In these sorts of posts I often mention not wanting to be zero weight any sector and not wanting to exceed 20% in any sector. Specifically I tend to be plus or minus a few percent of any sector's weight in the S&P 500. If the industrials currently take up 10% of the S&P 500, would anything between 6% and 14% of a portfolio allocated to that sector be speculation? Again, Bogle would say yes. Okay, so if this is speculation, is it reckless? What would the consequence of being wrong be?

If no more than 5% is in any one stock (I typically don't go more than 3% into one name), and you stray from the index weighting by a couple of percentage points or so, is this being reckless? (The assumption here is that there is no point in convincing someone it is not speculation.) Any hardcore passive investors out there know how Bogle might answer that?

Couldn't an argument be made that holding on o an S&P 500 index fund was reckless when tech grew to 30% of the market nine years ago? In that instance, holding an index fund may not have been speculative, but it might have been reckless. What is worse, speculation or recklessness?

As I said in my original reply, my idea of speculating would be something like whether or not to buy Research in Motion (RIMM) ahead of an earnings number. This is the sort of thing they talk about on the Fast Money halftime report every day, and not my type of trade. That being said, I am sure that some people that do trade that way would argue that even that is not speculation.

Trying to convince someone else that your idea of investing versus speculating is correct is pointless. What is useful is taking little bits of other peoples' ideas (i.e. process) on the subject and coming up with your own solution.