What is the difference between investing and speculating?
Investors who construct a globally diversified portfolio of index funds understanding that market prices incorporate all publicly available information (the Efficient Market Hypothesis) can expect a positive return over time commensurate with the risk they take.
Speculators, on the other hand, utilize individual stock picking, style picking and market timing in an attempt to “beat the market” and generate abnormal profits. Some classify speculating as excessively risky “bets.” In other words, speculating can be seen as gambling. Although you may beat the house every once in awhile, the odds are always in the house’s favor. French mathematician Louis Bachelier published his thesis “The Theory of Speculation” which concluded that the expected return of speculation is zero before costs (which implies negative return after costs).
My newly released documentary titled “Index Funds, The 12-Step Recovery Program for Active Investors” discusses in detail the differences between investing and speculating. The documentary can be viewed at www.indexfundsthemovie.com.
The main difference between speculating and investing is the amount of of risk undertaken in the trade. Typically, high-risk trades that are almost akin to gambling fall under the umbrella of speculation, whereas lower-risk investments based on fundamentals and analysis fall into the category of investing. Investors seek to generate a satisfactory return on their capital by taking on an average or below-average amount of risk. On the other hand, speculators are seeking to make abnormally high returns from bets that can go one way or the other. It should be noted that speculation is not exactly like gambling because speculators do try to make an educated decision on the direction of the trade, but the risk inherent in the trade tends to be significantly above average.
As an example of a speculative trade, consider a volatile junior gold mining company that has an equal chance over the near term of skyrocketing from a new gold mine discovery or going bankrupt. With no news from the company, investors would tend to shy away from such a risky trade, but some speculators may believe that the junior gold mining company is going to strike gold and may buy its stock on a hunch. This would be speculation.
As an example of investing, consider a large stable multinational company. The company may pay a consistent dividend that increases annually, and its business risk is low. An investor may choose to invest in this company over the long-term to make a satisfactory return on his or her capital while taking on relatively low risk. Additionally, the investor may add several similar companies across different industries to his or her portfolio to diversify and further lower their risk.
For more on diversification, take a look at Diversification: Protecting Portfolios From Mass Destruction.
This question was answered by Joseph Nguyen.
To me, the difference is largely one of time frame.
Lets offer an example. We have 2 ten year olds with $100.
Amy uses the $100 to buy lemons, sugar, an old table, and some poster board and sets up a lemonade stand on a busy road. Business is brisk, and she reinvests her profits by buying more supplies. By the end of the summer she has turned $100 into $500. Some days (rainy, cool days) business was slow, some days (the hot sunny ones) it was brisk. She was never discouraged. She did not throw up her hands on the first rainy day and say "no one is ever going to buy lemonade again - I'm going to sell my stand". She is an investor.
Johnny on the other hand goes and spends his entire $100 buying lemons, which he hopes to sell to Amy next week at a higher price. He heard the price of lemons will go up because the forecast is calling for record heat and lemonade is popular in the hot weather. Lo and behold, the forecast is wrong, the price of lemons drops, and Johnny is wiped out. Johnny is a speculator.
Speculators are forever trying to be smarter than the market. Investors simply participate in the markets. Speculating is akin to gambling. Investing is like going to work.
In short, the difference between investing and speculating is primarily that before you invest, you should do research (both fundamental and technical) and plan on holding the investment for a long period of time. However, speculation is when you buy or sell an asset before an earnings announcement, you transact the trade based on a gut feel or it is a bet that the asset will go down or up. The holding period is extremely short. You may hold the investment for minutes or days.
The simple answer is one is saving via growth and another is gambling. A true investor takes his/her time to study the investment he/she wants to purchase and do the due diligence. It also takes time and patience to become a successful investor. If buying at a discount thrills you, then bargain hunting for your favorite investment at a right price when most people are scared to purchase may someday reward you handsomely.
Speculating on the other hand, well, is just speculating. Hope and pray whatever your purchase will be worth some value. There’s definitely no guarantee for speculating.
Investment can risky, but depending on how you spread your risks, you may not lose everything you put in.