Investing vs. Speculating: An Overview
Investors and traders take on calculated risk as they attempt to profit from transactions they make in the markets. The level of risk undertaken in the transactions is the main difference between investing and speculating.
Whenever a person spends money with the expectation that the endeavor will return a profit, they are investing. In this scenario, the undertaking bases the decision on a reasonable judgment made after a thorough investigation of the soundness that the endeavor has a good probability of success.
But what if the same person spends money on an undertaking that shows a high probability of failure? In this case, they are speculating. The success or failure depends primarily on chance, or on uncontrollable (external) forces or events.
The primary difference between investing and speculating is the amount of risk undertaken. High-risk speculation is typically akin to gambling, whereas lower-risk investing uses a basis of fundamentals and analysis.
Investing can come in many different forms—through monetary, time, or energy-based. In the financial sense of the term, investing means the buying and selling of securities such as stocks, bonds, exchange-traded funds (ETFs), mutual funds, and a variety of other financial products.
Investors hope to generate income, or profit through a satisfactory return on their capital by taking on an average or below-average amount of risk. Income can be in the form of the underlying asset appreciating in value, in periodic dividends or interest payments, or the in the full return of their spent capital.
Most often, investing is the act of buying and holding an asset for the long-term. To classify as a long-term holding, the investor must own the asset for at least one year.
Let's consider a large stable multinational company as an example of investing. This company may pay a consistent dividend that increases annually, and it may have a low business risk. An investor may choose to invest in this company over the long-term to make a satisfactory return on their 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.
Analysis and research is a key part of the investment process. It involves evaluating different assets, sectors, and patterns or trends that occur in the market. Investors can use tools like fundamental or technical analysis to choose their investment strategies or design their portfolios. By using fundamental analysis, investors can determine what factors affect the value of securities, from microeconomic to macroeconomic factors. Technical analysis, on the other hand, uses statistical trends such as security prices and volumes to find opportunities in the market.
Investors have many options available for them to invest their money. Brokerage accounts give investors access to a variety of securities. By opening an account, an investor agrees to make deposits and then places orders through the firm. The assets and income belong to the investors, while the brokerage takes a commission for facilitating the trades. With new technology, investors can now invest with robo-advisers, too. These are automated investment companies that use an algorithm to come up with an investment strategy based on investors' goals and risk tolerance.
Speculating is the act of putting money into financial endeavors with a high probability of failure. Speculating seeks abnormally high returns from bets that can go one way or the other. While speculating is likened to gambling, it is not exactly the same, as speculators try to make an educated decision on the direction of their trades. However, the inherent speculative risk involved in the transaction tends to be significantly above average.
These traders buy securities with the understanding that they will be held for only a short period before selling. They may frequently move into and out of a position.
As an example of a speculative trade, consider a volatile junior gold mining company with 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. However, some speculators may believe the junior gold mining company will strike gold and may buy its stock on a hunch. This hunch and the subsequent activity by investors are called speculation.
Speculative trading does have its downfalls. When there are inflated expectations of growth or price action for a particular asset class or sector, values will rise. When this happens, trading volume increases, eventually leading to a bubble. This happened with the dotcom bubble. Investment in internet companies grew exponentially in the late 1990s, with valuations rising rapidly. The market crashed after 2001, causing major tech companies to lose a big chunk of their value, with many others being wiped out.
Types of Speculative Traders
Day trading is a form of speculation. Day traders don't necessarily have any specific qualifications, rather, they are labeled as such because they trade often. They generally hold their positions for a day, closing once the trading session is complete.
A swing trader, on the other hand, holds his position up to about several weeks hoping to capitalize on gains during that time. This is accomplished by trying to determine where a stock's price will move, taking a position, and then making a profit.
Trades and Strategies
Speculators can make many types of trades and use Some of these include:
- Future Contracts: Buyers and sellers agree to the sale of a specific asset at an agreeable price at a predetermined point in the future. The buyer agrees to buy the underlying asset once the contract expires. Futures contracts are traded on exchanges and are commonly used when trading commodities.
- Put and Call Options: In a put option, the owner of the contract has the right, but not the obligation, to sell any part of a security at an agreed upon price at a specified period of time. A call option, on the other hand, allows the contract owner to buy the underlying asset prior to the contract expiration date at a specified price.
- Short Selling: When a trader short sells, she speculates that the price of a security will drop in the future and then takes a position.
Popular strategies speculators use range from stop-loss orders to pattern trading. A trader tells a broker to buy or sell a stock when it reaches a specific price. By doing this, the investor is able to minimize his or her loss on the stock. Meanwhile, pattern trading uses trends in prices to identify opportunities. Used in technical analysis, investors employ this strategy by looking at past market performance to make predictions about the future of an asset—a feat which is generally very challenging.
Both investors and speculators put their money into a variety of different investment vehicles including stocks and fixed-income options. Stocks or equities represent a certain percentage of ownership in a company. These are purchased on exchanges or through a private sale. Companies are ranked by market capitalization or the total market value of their outstanding shares.
Mutual funds and ETFs are also popular investment options. A mutual fund is managed by a fund manager who uses the pool of money from investors to purchase various assets and securities. ETFs hold a basket of underlying assets, and their prices change throughout the trading day just like those of stocks.
Fixed-income assets include bonds, bills, and notes. These can be issued by corporations or various levels of governments. Many fixed-income assets are used to fund projects and (business) ventures, and pay interest before they mature, at which time the vehicle's face value is paid back to the investor. For example, a bond issued by the U.S. Treasury matures at 10 years or longer and pays investors interest bi-annually.
Investors may want to consider the holding period for their investments and their tax implications. The holding period determines how much tax is owed on the investment. This period is calculated from the day after the investment is purchased until the day it is sold or disposed. The Internal Revenue Service (IRS) considers holdings of one-year or more to be long-term. Anything below this is considered a short-term investment. Long-term gains are generally taxed more favorably than short-term ones.
Stephen Rischall CFP®, CRPC
1080 Financial Group, Los Angeles, CA
In general, the difference between investing and speculating is a long-term versus short-term time horizon.
Investing is synonymous with having the intention to buy an asset that will be held for a longer period. Typically, there is a strategy to buy and hold the asset for a particular reason, such as seeking appreciation or income.
Speculating tends to be synonymous with trading because it is more focused on shorter-term moves in the market. You would speculate because you think an event is going to impact a particular asset in the near term.
Speculators often use financial derivatives, such as options contracts, futures contracts, and other synthetic investments rather than buying and holding specific securities.
- The main difference between speculating and investing is the amount of risk involved.
- Investors try to generate a satisfactory return on their capital by taking on an average or below-average amount of risk.
- Speculators are seeking to make abnormally high returns from bets that can go one way or the other.