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I'm reading The Intelligent Investor by Benjamin Graham, and I'm on Chapter 1: Investment versus Speculation. On page 21, he has this footnote:

Speculation is beneficial on two levels.... Secondly, risk is exchanged (but never eliminated) every time a stock is bought or sold. The buyer purchases the primary risk that this stock may go down. Meanwhile, the seller still retains a residual risk—the chance that the stock he just sold may go up!

What does he mean by "risk is exchanged"? I think he's saying that the both the buyers and sellers have the possibility of losing money, but isn't that found in investment as well. Any clarification would be extremely helpful.

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Risk is exchanged in finance, because not every investor has the same risk tolerance. Risk in finance is most simply defined as volatility in future returns - it does not mean the same thing as 'loss'.

If you put $100 in the bank and it pays 2% interest, you will end the year with $102. Depending on your country, your government probably guarantees that your bank account is secure, so in finance that is called the 'risk-free rate'. That is: short of government collapse, there is no volatility in your returns; you know exactly what you will get.

Now suppose I offer you a $100 bet on a flip of a coin, and you win $204 if it is tails or get nothing if it's heads, then that is very risky - because your two different results are very different. You either double your money + an extra $4, or lose everything. This variance between 2 outcomes is what we call 'risk' in finance.

But now consider: If we do the coin flip bet 1,000 times, on average you come out ahead - because half the time you win $204, and half the time you win nothing - so you get 50% * 204 = $102 on average every time we play. **This is the same 'expected return' AKA 'average return' as if you had put your money in the bank earning 2% interest.

In the real world, the average person doesn't want risk - given 2 equal outcomes, the less volatile option is the preferred one. So if you have a risky proposal, you need to make it worth an investor's while.

This is why the average returns on the stock market exceed the risk-free interest rate (over time, average returns in the stock market can be seen as ~7%, depending on country and time period). That's because some years there is a market crash, and some years there is a market boom - even though the average return is higher, whether you want to invest in the stock market depends on your risk profile.

Not every investor has the same risk tolerance. Someone who is retired needs certainty over their future income, and someone young with lots of opportunities and time to recover is probably more willing to take on risk. So if I am 70 years old and own a coffee shop that gives me a 10% return every year, I might sell it to a younger person and earn 2% in the bank. I have exchanged my high-risk asset with low-risk cash. We both win, because we have different motivations - the young person earns more on average, and I have reduced my risk profile.

So when the author says 'risk is exchanged', they basically mean that risk is something you need to pay someone to accept. This is no different from paying insurance premiums so that the insurance company makes a profit and takes the risk of accident off of your hands.

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  • So, is he saying that speculation has a higher risk to it compared to investment, and thus a higher reward?
    – APerson
    Commented Mar 25, 2020 at 17:43
  • @APerson In a perfectly efficient market, yes, higher-risk speculation should be offset by higher reward. The less regulated / efficient / highly-traded something is, the less true this becomes.
    – Grade 'Eh' Bacon
    Commented Mar 25, 2020 at 17:47
  • That makes sense, but is that all that Graham is saying in that quote? Because in that quote, he's trying to give reasons why speculation is beneficial.
    – APerson
    Commented Mar 25, 2020 at 17:50
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    @APerson I don't want to bear the risk that my house burns down - that would be financially catastrophic for me. My insurance company wants the profits from insuring many houses, knowing that most will never burn down. So we both win, when I 'exchange' my risk to the bank. That is why it is beneficial. As to the concept that 'residual risk exists for the opportunity cost of lost profits'... that is a poor risk message from the author that I do not agree with.
    – Grade 'Eh' Bacon
    Commented Mar 25, 2020 at 19:21
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'Risk is exchanged' meaning risk is transferred from one hand to another, for money. you pay money for the opportunity but you also assume the risk. Thus you "purchase the risk" when you purchase the stock. As I understand this comment, the second benefit of speculation is the residual risk, i.e. buying the opportunity that the stock may rise even more. If that chance didn't exist, you wouldn't have bought the stock in the first place. Thus the benefit of speculation. To drive the point home, such benefit of speculation doesn't exist in high grade bonds, where the opportunity of appreciation is non-existent.

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