by John Raines

Created on: March 13, 2009   Last Updated: March 28, 2009

Smart investors speculate not by accident but by choice. Smart investing is a way of thinking about investments using objective measures to estimate real value. By identifying actual value the investor always knows when they are investing and when they are speculating.

Recognizing speculating is not always easy but, to paraphrase Judge Stewart, "You may not be able to define speculating but you know it when you see it". There are traits that separate speculating from investing and part of smart investing is learning to "know speculating when you see it".

Smart Investors Buy Value

The first thing a smart investor examines is value and this focus differentiates investing from speculating. For these investors the difference between price and value is crucial. Some might think that price should equal value, but if that were always true there would be no bargains. And smart investors are very keen on finding bargains so they use financial tools to estimate values. Only by comparing value to price can they find fairly valued or, more desirably, undervalued investment opportunities.

Most investments have an abundance of data available for value estimates. For common stock and corporate bonds there is information in annual reports, SEC filings and financial news. Bonds have rating agency information. For any investment there should be sufficient date for an informed decision. Real estate investors use appraisers for example. The lack of information is a strong indication an investment is speculative.

Discounted cash flow (DCF) techniques based on estimated cash flows provide the most accurate estimate of value for any investment. However, precise calculations are not required to estimate values. Statistics comparing company data to market prices such as price-earning ratio or book value per share vs price give rough estimates of value and are readily available. By developing the knowledge and skills to use financial data an investor can make very reasonable estimates of value.

Analyzing potential investment takes time and experience. If just the thought of reading a financial statement makes your head hurt or you get hives looking at columns of numbers, there are still investment opportunities. Many good investment vehicles, such as mutual funds, are run by professional money managers. Although investors still must look at data, it is less intimidating and only three or four funds are needed to have some portfolio diversity.

In sum, a smart investor estimates value using

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