Is it Investing, or is it Speculating?

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Investing, speculating, and gambling are as old as civilisation itself.

The first historical reference to investing comes from the Babylonian Code of Hammurabi in 1700 BCE, which describes some of the basic rules of investing, loans, and financial transactions.

The history of gambling goes back even further to Mesopotamia in 3000 BCE, with the first record of a six-sided dice. In China, gambling houses were commonplace in the first millennium BCE, and playing cards appeared there in the 9th century AD, with lotto games following in the 10th century.

The first casino opened its doors in Venice in 1638, and poker was popularised in the saloons of America’s Wild West in the 1830s.

The idea of making fast money has always been incredibly alluring, and according to studies this is the main reason why people like to speculate. People also like the fun and the ‘buzz’ that comes with the experience.

However, speculating can go very wrong, so it’s vitally important that we know the difference between when we’re investing and when we’re speculating.

The definitions

Investing by definition, is putting money into an asset or a commercial venture with the expectation of achieving a profit. It is a long-term strategy that is focussed on security and stable returns.

Examples of investments include stocks, bonds, ETFs, property, and cash.

Speculating is the execution of high-risk bets, where there’s a chance of making outsized returns, but also the chance of losing the lot. Speculative investments can be highly volatile and are often absent of a long history and sound regulation.

Examples of speculative investments include options, futures, currencies, cryptocurrencies, junior miners, biotechnology companies, and technology start-ups.

Grey areas

Within any comparison like this, there will always be grey areas. Some small-cap companies, for example, could be classified as investments, if they have strong competitive advantages and stable earnings. Also, some assets that would normally be considered investments (e.g. property), may be considered speculative if they are bought at excessive prices.

Can investors own speculative stocks? Yes, but it should only be a small percentage of an investor’s portfolio.

There will be times when investors can receive outsized rewards by doing a lot of research on high potential, yet undiscovered, small caps.

Speculative Bubbles

One of the biggest dangers of speculation is when it becomes rampant. When people notice others becoming rich from the stock market, they often want a piece of the action. The result is a rising market, which turns into a speculative bubble, that eventually bursts.

Charlie Munger laments the ‘mania of speculation’ that appears in markets from time to time. He said, ‘It’s weird that we ever got a system where all this equivalent of casino activity is all mixed up with a lot of legitimate long-term investment. I don’t think any wise country would have wanted this outcome’. And he’s probably right.

In the recent downturn, it was no surprise that the hardest hit were speculative assets, such as cryptocurrencies and unprofitable tech.

Is it Investing or Speculating?

Here are seven factors that can help determine if an investment is investing or speculating:

  1. Duration. Investors typically invest for the long term in well-established companies. The timeframe for speculators is much shorter, often less than a year, where there is a hope for a quick and sizeable gain.
  2. Risk. Investors have a lower risk appetite, which also enables them to reach their financial goals. Speculators have a much higher risk appetite, which provides the potential for a big win, but also for big losses. Investors have a much higher probability of getting their capital back.
  3. Risk mitigation strategies. Investors can deploy a number of strategies to lower their risk. The most common method is diversification, which protects the portfolio from the fall of any one stock. Investing for the long-term also helps smooth out the peaks and troughs in the market. Speculators have very few options for risk mitigation.
  4. Returns. Investing typically provides a return on the investment, such as a dividend, rent received from a rental property, or interest from a term deposit. As speculators usually buy into newer companies that are typically loss-making, there aren’t any dividends to deploy.
  5. Odds. Historical data shows that the odds of positive returns for long-term investors are favourable. Speculators also have favourable odds of positive returns, though the peaks and troughs are much more pronounced. Hence speculators can still lose their shirt if they have a bout of bad luck.
  6. Information. Investors have much better access to information on their investments, due to the fact their investments are well known and established. As speculators often buy into newer companies, the history is short, and the technology is often untested.
  7. Financial data. As most of an investor’s investments are profitable, a range of common ratios can be used for analysis, such as a Price/Earnings ratio. As a speculator’s companies are often unprofitable, speculators can only use less reliable ratios such as revenue multiples, and their instincts.