Broadly speaking, the stock market is made up of investors and speculators. When you invest in an asset or financial product, you expect to make a return. You also expect to receive all your capital back when you sell the asset. If you speculate on an asset, you are hoping for the price to move in your favor – but you are aware that it may not.
In today’s complex financial markets, the line between investing and speculation is less distinct. This article looks at the key differences between the two, and lists examples of investing, speculation and the grey area between the two.
- What is investing?
- What is speculation?
- Investing vs. speculating: Key differences
- The grey area between investing and speculating
- Examples of investing
- Examples that can be categorized as investing or speculation
- Speculation examples
- Pros and cons of investing
- Pros and cons of speculating
What is investing?
According to the dictionary, investing is defined as “committing capital in order to earn a return.” When it comes to the financial markets you invest in assets when you expect a return, and you also expect to receive the initial investment back. This doesn’t mean investments are without risk – but the expectation is that the risk is low. Most investments create cash flows like interest, coupons, rent or dividends. However, in some cases, profits are reinvested to add value to the asset.
What is speculation?
Speculating means committing capital in the hope of making a return. Speculation is typically based on a theory about what will happen in the future. However, there is no certainty, and the risk is far higher. During a gold rush, people who went looking for gold were known as speculators. They had no way of knowing whether they would find gold, but where prepared to take the risk because reward would be far greater.
Speculation dominated in the early days of Wall Street when most listed companies didn’t have a track record. However, nowadays hundreds of companies have long track records. Investment analysis has come a long way too. Investors can now buy certain stocks with a lot more certainty.
Investing vs. speculating: Key differences
In The Intelligent Investor Benjamin Graham wrote: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
The key difference between investing and speculating is the level of risk and the certainty of receiving your capital back. Investors are reasonably certain they will not lose money. Speculators on the other hand, know there is a reasonable likelihood they will lose their investment.
If you do lose money on an investment it should be because something unexpected happens. If you are not surprised by a loss, you are very likely speculating. Speculators chase high returns, rather than high probability returns. Speculation is typically more short term in nature, though some speculative investments do have a long time horizon. Speculators usually expect the price of an asset to change. Investors look for cash flows, or for the value of the asset to change.
Active investing can be more speculative, but that doesn’t mean active investing is the same as speculation. Solid fundamental analysis is more likely to result in investments than speculation. However, thorough analysis can also result in speculative investments. You may do your research and conclude that a stock has a fifty percent chance of going to zero and a fifty percent chance of tripling in value. For every dollar you risk you will either lose one dollar or make two. This is a speculative bet, but it’s a bet worth taking.
The difference between investing and speculating can also depend on the person making a financial transaction. Consider two different investors buying the same stock. The first investor may have bought the stock based on nothing but a hunch. The second investor may have bought the stock after doing a lot of research and have a very sound investment thesis. The first investor is speculating, while the second is investing. In this case the difference comes down to each approach, not the stock itself.
The grey area between investing and speculating
In many cases it is very clear that you are either investing or speculating. But in some cases, an investment could be classed as either. Small cap stocks for example are typically speculative. But some small companies have predictable earnings and a competitive advantage. If you can invest in these types of companies at a fair price, you are not speculating.
Hedge funds range between highly speculative and what most people would regard as being investments. Furthermore, when a fund employs active trading strategies, individual trades may have speculative characteristics. However, if the system is based on empirical research, investing in the fund itself is not necessarily speculative.
Using quantitative investing techniques removes a lot of the speculative element from trading systems. Catana Capital’s Data Intelligence Fund is a good example. Trade signals are generated as a result of a deliberate process involving artificial intelligence, big data and sentiment analysis. The objective of such a fund is to reduce portfolio risk, which is something investors – not speculators – do.
Examples of investing
The following are examples that would almost always qualify as investing:
- Savings accounts
- Government bonds
- Blue chip stocks
- Value stocks
- Passive investing / ETF investing
- Robo advisor platforms
- Retirement plans
- Mutual funds
- Factor investing
- Private equity funds
Savings accounts are one of the safest types of investments. If you invest in a savings account your money is almost certain to be safe, and you know roughly what compound interest you will earn. Most savings accounts are guaranteed by governments up to a certain amount.
Government bonds issued in developed countries are also very safe. A government can print money to pay back the principle. This may weaken the currency, but the principle will be safe.
Blue chip stocks do carry some risk but are generally regarded as safe investments and they have predictable earnings. Companies regarded as “blue chip” are very unlikely to go bankrupt, though their value may fall in any given year. A portfolio of blue-chip stocks is unlikely to lose value over a 5 to 10-year period.
Value stocks are regarded as having limited downside. If a stock is trading below its intrinsic value, the worst-case scenario is that common stock owners would be entitled to the liquidation value of the company. Value investing seeks to limit the downside first, and then earn a return.
Stocks with low PEs are not always value stocks though. One of the most common investing myths is that low PE stocks are a good investment. While some stocks trading on low multiples are good investments, many are cheap for a reason. Likewise, some of the best performing stocks trade on high multiples. Although the downside on value stocks is limited, investors will only earn a return if the company’s prospects improve, and the market recognizes it.
Passive investing and ETF investing generally falls under investing rather than speculation. Market capitalization weighted ETFs will always contain the most valuable stocks in each market. Owning the most successful stocks over the long term has a high probability of earning investors a return. Actively trading ETFs is speculating though, just like it would be for most stocks.
Robo advisor platforms offer cautious investment strategies. In fact, a large part of what they do is aimed at steering investors away from speculating. Robo advisors invest client assets in passive income investments according to a prudent asset allocation framework.
Retirement plans, balanced funds and annuities are relatively safe investments. Most of these long-term savings products are highly regulated to ensure that capital isn’t invested in speculative instruments.
Mutual funds are for the most part regarded as investments. However, some are very speculative depending on the strategy they follow, or the instruments they invest in. Actively moving money in and out of mutual funds is speculative, regardless of the fund.
Factor investing and ESG investing typically form part of an investment strategy. The research these types of investments are based on looks at factors that lead to long term outperformance and profitability. Traders don’t usually use these types of factors for speculation either.
Private equity funds invest in private companies with proven business models. In fact, private equity funds usually invest in companies once their speculative phase is over. They accept lower returns but have a higher success rate than venture capital funds.
Examples that can be categorized as investing or speculation
The following examples fall into the grey area between speculation and investing:
Momentum investing is speculative in nature. Investments are not made with any degree of certainty. Rather, momentum is used to signal the fact that other investors are likely to pay higher prices in the future. However, a diversified momentum portfolio that is based on empirical research can remove a lot of the uncertainty. The same can apply to any stock picking strategy.
Growth stocks are often priced as though they will continue to grow earnings rapidly for several years. Buying stocks like this is usually speculation. A popular investment will usually trade at a premium, and there may not be enough growth to justify the premium. However, an investor may conclude from their research that the required growth is achievable.
Hedge funds and algorithmic trading strategies can be used to speculate. But they can also be used to hedge against volatility or a stock market crash. In this case they are being used as part of an investment strategy.
Real estate can easily fall into the realm of either investment or speculation. A rental property that generates positive cash flow is an investment. On the other hand, investment of money into a property that will only be profitable if its resale value increases is speculation.
Venture capital funds typically invest in startup businesses which are speculative. However, one can argue that a fund which is diversified across numerous startups some of the risk has been reduced. Whether or not the fund is speculative is a matter of opinion.
Examples of speculation
The following are examples that almost always fall into the realm of speculation:
- Short selling
- Startup investing
- ETFs that invest in new industries
- Mining exploration stocks
- Biotechnology stocks
Derivatives, including options, futures contracts and CFDs, are most often used for speculation. The same applies to trading any financial instrument on margin. Even if the underlying asset can be regarded as an investment, the use of leverage will usually make a derivative speculative.
Short selling is often speculative, unless it forms part of a hedging strategy. When you short a stock, you can never be sure the price will not rise. When there are too many short positions, a short squeeze will often occur, causing traders to buy back their shares at higher prices.
Startup investing is generally very speculative. Startups have little or no revenue and no track record. Until their business model has been proven, there is no certainty of return.
ETFs that invest in new industries are generally speculative. Recent examples have been funds that invest in cannabis stocks, cryptocurrency and blockchain technology. In time these funds may qualify as investments, but until the companies are profitable, they are speculative.
Mining exploration stocks are those of companies that explore for new energy and mineral reserves. These companies can be very profitable if they do find new reserves. However, there is no certainty that they will “strike gold”, or that the reserves they find will justify the cost of exploration.
Biotechnology stocks are mostly speculative. These companies only earn a profit if the drugs they develop make it through clinical trials and regulatory approval. Until that happens, there is a high level of uncertainty.
There are other types of trades and investments that are speculative. Buying a company in anticipation of a takeover is one. Betting on a successful turnaround of an insolvent company is another. Anticipating regulatory changes or central bank activity is also speculative.
Pros and cons of investing
When you invest, you are unlikely to lose the entire amount you commit. You will also have an idea of the return you are likely to generate. Investing comes with a higher degree of certainty. This means you can invest toward very specific goals – provided time is on your side.
The biggest downside for investors is that returns are not likely to be very high and they will take time to earn. The best investors in the world have long term annualized returns of around 20 percent. And, even those returns come with a fair amount of volatility. Annual investment returns are more likely to be in the 5 to 15 percent range, depending on the amount of volatility an investor is prepared to accept.
Pros and cons of speculating
Speculation can mean higher returns. It can also mean returns are earned faster. But of course, there is no certainty of either. Speculation also means you can be rewarded for doing your own research and for any unique knowledge you acquire and develop. Speculative investments can be used to improve the returns of an investment portfolio. Contrarian speculative trades can also be used to reduce the volatility of a portfolio.
The downside of speculation is that there is a high level of uncertainty and real risk of loss. While speculation can lead to wealth, you cannot speculate toward a goal. Speculation requires higher risk tolerance. If you are likely to make irrational decisions when you are under pressure, speculating is best avoided.
Conclusion: Investing vs. Speculating
Some speculative holdings will probably be required to boost the returns of an investment portfolio. However, as the number of speculative investments increases, so does the uncertainty. Some instruments, assets and funds can be both investments and speculative. Knowing how to differentiate between the two, allows you to decide how much of your portfolio to devote to each.