The biggest mistake an investor commits occurs when he or she forgets that they are actually buying into a business, not a stock. By all accounts, I would guess that around 85% of the individuals who own stocks assume they are investing in companies when they are indeed speculating on stocks.

Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.

A Fundamental Difference

The difference between investing in a business and speculating on a stock is significant and expensive. Facebook (Nasdaq:FB) is a perfect example of what can happen when individuals mistaken investing for speculation. Buying into the Facebook IPO at a roughly $100 billion valuation was a pure gamble on the hope the someone would be in line after you to buy in at a higher price. Even if the IPO had valued the company at $75 billion, owning Facebook was a big gamble at those prices. Despite Facebook's fast growth and future potential, the company's revenue model is still new and untested.

So to pay $100 billion for a business that earns less than $1 billion in profit and the future profit potential is still widely uncertain was act of stock speculation, not business investment. Now FB shares are down over 20% from the IPO price and many investors are screaming mad looking for someone to blame. Several months ago, investors were warned when social buying site Groupon (Nasdaq:GRPN) had a much hyped IPO that has turned out terribly. Shares in Groupon now trade for $11, well below its IPO price of $20. Both Groupon and Facebook now trade at or near their lowest prices and those prices could easily head lower.

SEE: How An IPO Is Valued

A Time Tested Approach

Truly investing in a business via buying the stock requires a lot of conditions that serve to eliminate many investing mistakes. First, when you invest in a good business, you are likely going to hold on to it for many years, as good investments are quite hard to come by. Whether is a blue chip giant like Coca-Cola (NYSE:KO) or a smaller name like AutoZone (NYSE:AZO), these excellent businesses have created magnificent value for investors who were content to hold on to them for years. It's no coincidence that Warren Buffett has held on to his Coke investment for nearly 30 years now and hedge fund wizard Eddie Lampert bought a huge chunk of AutoZone over a decade ago and still retains a sizable interests. These are excellent companies that anyone would be lucky to own outright for decades. Thankfully, owning stock, or a partial interest in the company is the next best thing.

The Bottom Line
Understanding the fundamental difference between owning a business and speculating on a stock is essential to creating long-term investment value or risking making very expensive speculative choices.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Sham Gad did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  2. Investing News

    Who Does Cheap Oil Benefit? See This Stock (DG)

    Cheap oil won't benefit most companies, but this retailer might buck that trend.
  3. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  4. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  5. Investing News

    Today's Sell-off: Are We in a Margin Liquidation?

    If we're in market liquidation, is it good news or bad news? That party depends on your timeframe.
  6. Stock Analysis

    Drone Wars: DJI Vs. Intel (INTC)

    Find out which drone technology leaders, Intel Corporation or DJI Innovations, is most likely to emerge victorious in the coming drone wars.
  7. Investing News

    Bank Stocks: Time to Buy or Avoid? (WFC, JPM, C)

    Bank stocks have been pounded. Is this the right time to buy or should they be avoided?
  8. Stock Analysis

    Why the Bullish Are Turning Bearish

    Banks are reducing their targets for the S&P 500 for 2016. Here's why.
  9. Stock Analysis

    How to Find Quality Stocks Amid the Wreckage

    Finding companies with good earnings and hitting on all cylinders in this environment, although possible, is not easy.
  10. Investing

    Adobe Systems: A Company In Transition (ADBE)

    Adobe Systems is undergoing a major change to its business model. We take a look at its strategy, challenges, and performance.
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center