So, are you an investor or a speculator?
The sad truth for many inexperienced investors is that they don’t know the difference. They might believe they are making smart choices when in reality they are gambling with their financial future.
But that doesn’t have to be your fate.
This article explains what every beginner needs to know about investing vs speculating:
- What is the difference between investing and speculating?
- Is speculating gambling?
- Is there a place for speculating in my portfolio?
By understanding the risks and rewards of each approach, you can make informed (and more profitable) decisions. And you can avoid the lure of quick profits that often leads to painful losses.
Investing vs. Speculating: The Principles of Investing
Investing is buying an asset with the expectation that it will generate a positive return, often measured in years or even decades. Investing is not chasing the latest Reddit stock tip or trying to predict where the market will be next week.
Fundamental Principles for Successful Investing
Successful investing is grounded in the following six fundamental ideas:
Identifying investment opportunities is about doing your own research. If you are interested in a stock, study the company inside and out. If you are considering real estate, research the area and local pricing trends.
Sound investments are often based on a proven (historical) track record. If a company has grown earnings for the past 20 years, it’s not unreasonable to expect them to continue to do so.
2) Long-term Vision
Make investments with an eye on future growth, not just immediate returns. The best investments take time to develop. For example, if you had bought $10,000 worth of Apple stock in 2003, it would be worth over $5 million today!
3) Risk Assessment
Risk and reward go hand in hand. Low-risk investments tend to provide low to moderate returns, while riskier investments can introduce the possibility of greater returns. Make sure that you understand and are comfortable with all the risks involved in investment before you commit your money.
4) Expectation Of Profit
Investments are made with the expectation of profit. Of course, not every investment will go your way. But the key differentiator here is that your decision is based on thorough research, sound reasoning, and a long-term outlook rather than short-term price fluctuations or market hype.
Focus on an asset’s intrinsic value rather than its current market price. Warren Buffet made his fortune buying stocks that had fallen out of favor, despite their financial strength and competitive advantages. This is known as value investing and it can be a powerful strategy to build wealth.
6) Manage Leverage
Most investments are made without using borrowed funds. However, real estate is one exception (as investors rely on mortgages to build their portfolios). Leverage will amplify your returns when things go right, but it also magnifies your losses when things go wrong. So no matter the context, be sure to use it with caution.
Define Your Investment Objectives
Once you understand the principles of investing, you have to determine your individual goals. Do you need consistent income to meet your monthly expenses, or are you interested in long-term growth?
Here are five ways to look at evaluate a potential investment:
- Wealth Accumulation: Focus on investments that have the potential for long-term growth.
- Income Generation: Create a steady stream of income, through dividends, interest, or rental income.
- Inflation Hedge: Protect the purchasing power of your money from the eroding effects of inflation.
- Risk Management: Diversify your investments across different asset classes to minimize the effects of market volatility.
- Minimize Tax Liability: Structure your investments tax-efficiently, like using an IRA to defer capital gains taxes.
Choose The Right Investment Vehicles
Now that you have your objective, it’s time to choose where to put your money. Here are a few popular investment options to consider:
- Equity investments: Stocks offer the potential for capital appreciation and dividend income.
- Debt investments: Bonds are ideal for generating steady income with minimal risk.
- Real estate: Real estate can provide rental income, capital appreciation, and inflation protection.
The Lure of Speculation
Speculating involves a much lower degree of certainty than investing does. As a result, it can feel more like a roll of the dice. However, it is not gambling.
To understand the difference, think about the game of Blackjack.
A Blackjack player bets $1, and there are two potential outcomes. They can either win $1 (roughly 45% of the time), or they can lose their dollar (roughly 55% of the time).
Even if you play Blackjack perfectly, you are expected to lose ~$0.10 per play. And there is nothing that you can do to change those statistics. It is a game of luck — it is gambling.
Speculating, on the other hand, is not purely luck. Talented investors are often able to identify an edge that tips the scales in their favor. This could be a value-add strategy in real estate, a quality of successful founders in venture capital, or a marketing advantage in crypto.
In these scenarios, speculators might be comfortable placing bets even if the odds that any individual opportunity succeeds are low. They know that when they get a bet right, it will pay off 10 to 1 or even 100 to 1.
In this way, the outcome isn’t dependent on luck but on their ability to identify good bets. Speculators know that most bets won’t pan out, but just a couple of big winners can make it all worthwhile.
So, now that we understand the strategy of speculation. Where can it go wrong?
Risks Of Speculating
- FOMO Driven: The Fear Of Missing Out (FOMO) is a common motivator for beginners. That little voice in your head tells you to buy the latest cryptocurrency because your friend tripled their money in just a week, and you don’t want to miss the boat. Remember, even speculation should involve research. Never jump into a hype cycle you don’t fully understand.
- Short Time Frame: Don’t make decisions based on recent news or price action. Stick to the fundamentals. If you find yourself trying to capitalize on current trends rather than the asset’s underlying value, you may get burned.
- Leverage: Many failed speculators utilize borrowed funds or margin. Of course, this can significantly boost your returns but it’s a double-edged sword. So if you are not careful, you may put all of your capital at risk.
- Repeated Losses: The reality is that most speculations result in losses, and one win can more than outweigh countless losses. As a result, it’s critical to keep the trade size small so that you can stay in the game and reap the rewards.
Popular Ways To Speculate
For those interested in speculating, the following assets are popular choices. Each comes with its own set of risks that you should be intimately familiar with before getting started.
- Options: These contracts give you the right, but not the obligation, to buy or sell stocks at a fixed price within a given timeframe. If the stock does not reach the expected price during the agreed-upon timeframe, the option will expire worthless.
- Futures: A future is an agreement to buy or sell an asset or commodity at a future date at a fixed price. However, futures only require you to put up a small percentage of the asset’s purchase price. This is known as leverage. So if prices move in your favor, gains can be significant. And if they move against you, you can lose more than your initial capital.
- FOREX: The foreign exchange market allows you to trade currencies. FOREX also offers high leverage, so even small price movements in the underlying currency can result in substantial profits or losses.
- Cryptocurrencies: These are digital currencies, such as Bitcoin and Ethereum, that operate on blockchain technology. Known for their extreme volatility, they can experience rapid price fluctuations, offering both high-risk and high-reward outcomes.
- IPOs: An Initial Public Offering presents an opportunity to invest in a company when it first becomes publicly traded. However, since these companies are new to the public markets, they are often highly volatile during an initial period of “price discovery”.
- Penny Stocks: Penny stocks are shares of small companies that trade for less than $5. These companies are sometimes speculated on for their potential upside. However, it’s worth noting that penny stocks are not subject to the same rules and regulations that companies on larger exchanges are.
While 10x and 100x returns on your initial investment can be enticing, speculating comes with significant risks. So if you choose to take the high-risk, high-reward path, be sure to have a carefully formulated plan.
Investment vs. Speculation: Can You Do Both?
Speculation is risky. And it can lead to a 100% loss of your investment. But that doesn’t mean there cannot be a place for speculating in a diversified portfolio.
While you should proceed with caution, incorporating a small amount (say 1% to 5%) of your portfolio into your investment strategy can provide some advantages:
- Greater Returns: By owning some speculative assets, you can potentially increase your overall returns without taking on an inordinate amount of risk.
- Capitalize On Trends: You may be able to take advantage of current market conditions without changing your overall investment strategy. For example, buying put options on the S&P 500 might allow you to profit during a market downturn.
- Portfolio Resilience: Uncorrelated speculative assets can act as a buffer for the remainder of your portfolio during market corrections.
- Capitalize On Market Disruptions: Asset prices can skyrocket when new technology or innovative breakthroughs hit the market. Look no further than the crypto bubble and now the AI bubble. While game-changing companies will always emerge, there are far more losers than winners in these spaces.
- Liquidity Boost: Speculating can offer quick wins, unlike traditional investments that may take years to significantly appreciate. When a speculative trade pays off, it can result in a sizable inflow of cash to your account.
How To Speculate Cautiously
If you plan on incorporating speculation into your investment portfolio, here are 7 tips to help you do so wisely:
- Maintain Separate Accounts: Keep your investments and speculative assets apart for easier tracking.
- Limit Speculative Exposure: Cap speculation at ~5% of your total portfolio to manage risk.
- Review More Frequently: Speculative assets are volatile, so you need to monitor them much more closely than normal.
- Diversify: Just like your overall portfolio, don’t put all your speculative eggs in one basket. Spread your 5% portfolio allotment across a basket of potential ideas.
- Exit Strategy: Always have a plan for getting out. This could be a profit target a stop loss, or both.
- Education: Dedicate time to studying the asset class you are diving into. The better you understand the market, the better you will be at evaluating opportunities.
- Separate Emotions From Decisions: Volatility can wreak havoc on your emotions. One minute your account is up and you are on cloud nine. The next, prices are down, and you are in the dumps. So stay disciplined and stick with your exit strategy. This will help you know when to take profits or cut and run.
Investing provides the foundation for long-term stability and growth in your financial portfolio. Speculating, on the other hand, offers the allure of quick gains but comes with substantially higher risks.
When deciding between investing vs. speculating, it’s possible to take advantage of both. But it requires extreme caution.
Think of speculating as taking an unknown shortcut to speed up a road trip. Sure, you might save time. But you also might hit a dead-end that sets you back. And with your finances, a dead-end is the last place you want to be.
So diversify, be mindful, and proceed with caution. After all, your financial future is at stake.