Understanding Investing and Speculating

It’s time to break down the difference between investing and speculating. At different points in market cycles and throughout stock market history investing has been thought of as speculating and speculating as investing. With the latest boom and bust of weed stocks, last years run up of crypto and the resulting crash, the longest bull market in US history, and now movements in to correction territory it’s more important than ever to understand the differences.

We get it, diving into the world of investing can be tough. There are so many different ways to lose money and it’s easy to fall in to a trap. One of the many pitfalls that most new participators in the market come across, and one we all definitely fall prey to, is speculation. I made a lot of uninformed and rash decisions that I would never make now and lost, at the time, quite a bit of money. And while we still learn every day about the markets, this lesson of investing vs. speculating should be learned quickly and forgotten.

At the highest level I would say every market involves some sort of speculation. If you hold the S&P 500 through index funds (which is one of our favorite ways to invest) you are speculating that the US economy is going to continue to grow. If you hold treasury bonds you are technically speculating that the US government is not going to default on its debt and will have the ability to pay you back (which has actually come close to happening in recent years). There are people who purposefully make speculative investments and they have their own reasons for doing it. We are just here so you understand the difference and don’t accidentally speculate when you meant to invest.

Investors tend to seek to maximize their risk adjusted rate of return based upon fundamentals, through analysis, risk management, and due diligence. Speculators buy a security with the hope that someone else will buy that security from them at some point in the future at an even higher price than they payed for it. Burt Malkiel of Random Walk Down Wall Street fame presented this idea the best with his castles in the air analogy. Let’s dive into some examples of each:

Speculating

A great example of speculation are small cap biotechnology stocks.  The underlying businesses usually don’t make much money if any and are operating with money raised by issuing equity and grants they have secured for researching new drugs.  However, an FDA review of a drug they are trying to bring to market can either make or break the business. Speculators will buy up stock or short it (usually on margin) right ahead of these reviews seeking to create outsized returns.  While speculators can read all the company press releases they want the FDA approval process is extremely complex. No one really knows what’s going to happen and people make small fortunes or get burned all the time.

But you don’t have to take our newest high tech example to find speculation in the markets. Ever heard of Dutch Tulip Bulbs? One of the greatest financial bubbles and speculation crazes of all time. That’s right. Tulip Bulbs. People actually bought and sold flowers that costed more than their homes. And they bought them on margin. And as all speculation crazes do and all bubbles must, they popped. People lost fortunes.

Check out these other speculation crazes to see how ridiculous and irrational people can get.

Weed stocks, biotech, Housing, dot com bubble, savings and loans, south sea company, tulip bulbs.

Investing

A good example I like to use for investing is something that you can conduct research on and conclude that it will have positive expected returns with average or lower than average risk for many years to come.  

Take a large conglomerate that is in several industries.  It is a top player in the industries that it participates in and returns value to shareholders through either dividends, share buybacks, or capital expenditures.  An investor might choose to invest in this company to seek a modest return on the capital they put at risk as due diligence suggests that the business’s risk is relatively low.  Additionally, the investor might go ahead and purchase stock of similar companies to diversify their portfolio across industries and regions.

Remember that purchasing a share is not just owning a string of numbers running across your screen with the hope those numbers go higher. It is a ownership position in the company of whose share you bought. The value of your house is not told to you consistently throughout your day and you don’t care. Your investments should be the same. Even if you are not able to know the price you should be comfortable in your investments, and I stress investments and not speculative positions, that if you didn’t know the price at this very moment you would be happy to own a piece of that company.

Conclusion

We are not saying to not speculate. Some make their fortunes on speculation but many more lose fortunes because of speculation. It’s important to understand the differences and the risks acclaimed with both. Yes, investing has it’s risks and while they are different from speculating they are always present and represent hurdles that intelligent investors must learn to navigate.