What is the difference between investing and speculating?
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.
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.
In general, the difference is long term versus short term.
Investing is synonymous with having the intention to buy an asset that will be held for a longer period of time. 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. Often times speculators use options, futures, and other synthetic investments rather than buying and holding a specific security.
Stephen Rischall, CRPC
Back in 1934, Benjamin Graham and David Dodd tried to make the distinction in their book “Security Analysis.” According to the authors at that time, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
As liberally as the term investor and investment is applied today, this simple, and seemingly accurate enough, definition appears confusing to some. The confusion is understandable.
Across so many modern cultures, the investor, and, in particular, one who has demonstrated an ability to make make a profit, has been mythologized to some extent. At the same time, the speculator is written off as a reckless gambler; or worse, a fool.
Unfortunately, these interpersonal tags are often applied in hindsight to actions that, if evaluated in advance, would have fallen under a simplistic definition of speculation. Those that allocate their assets to a speculative endeavor – according to the Graham and Dodd definition – that results in profit might be considered a shrewd investor, because the proof is in the pudding. However, had the endeavor been of the losing variety, the same shrewd investor may have been labeled a reckless speculator.
The point is that, if a realistic distinction is to be made between investment and speculation, it must be made in advance.
In my, personal, opinion, a black and white distinction cannot always be made between the two. Rather, any activity we undertake with our assets with a reasonable intention of financial gain might be placed on a spectrum ranging from investment to speculation.
In my opinion, the factors that would place an allocation closer to one side than the other would depend upon what can be known about, and what is believed to be known about, the mechanics of how the allocation is expected to generate a return over time, and the level of confidence associated with an expected rate of return over time. The more that can be known about, and is believed to be known about, how the allocation will produce an expected return over a prescribed timeframe, and the higher the degree of confidence associated with an expected rate of return over time, the closer the allocation might be to the investment end of the spectrum. (It seems that, under this definition, a game of chance like roulette would fall closer to the investment end of the spectrum, as much is known about the mechanics of return, and an expected rate of return can be predicted with great confidence over a long enough period of time. With a long enough allocation horizon, it would be appropriate to put roulette closer to the investment end of the spectrum, at least for the house. For the gambler, with an expectation of almost certain loss over a long enough period of time, roulette would violate the “reasonable intention of financial gain” requirement and not fall on the spectrum at all.)
The tricky part here – again, in my opinion – is that it is very easy to fool ourselves into believing that we know more than we do. That is, I believe that many, even among the most highly lauded “investors,” occasionally allocate assets to endeavors that fall closer to the speculative end of the spectrum than they believe at the start.
All of this, of course, presumes some attempt to understand anything about where, when, how, and why assets are allocated. In reality, there are no shortage of entities, natural or otherwise, that allocate assets to endeavors about which little is known other than that it, or something similar, has increased in value in the past, and there is hope that it increases in value in the future. Although many of these entities might consider themselves investors, it would be difficult to place this activity closer to the investment end of the spectrum than to the speculative, even if it ends up being profitable.
This is a great question, in part because it has no easy answer. Personally, I define speculation as the use of money (to purchase an asset) where the purchaser is prepared to lose 100% of the asset value, even if such an outcome is not likely. Presumably, the speculator would only accept such risk if the potential rewards were viewed as substantial and, in some sense, commensurate with the very real risk of a total loss.
An "investor," in contrast, expects with a high likelihood to preserve and enhance the overall value of the asset (or portfolio) over the relevant time horizon. Time horizon is critical here. The same asset could be viewed as highly speculative in one time horizon, and a prudent investment in another. Here's an example. Someone who buys an S&P 500 exchange-traded fund (ETF; for example, SPY) at 10 am and plans to sell it at 11 am arguably is speculating. Although a total loss is virtually impossible in the one hour holding period, conversely there is no strong theoretical or empirical basis for placing a high likelihood on experiencing portfolio growth over that hour. It's more like a coin toss.
In contrast, a 21-year old with a Roth IRA can make a reasonable argument that putting 100% of the Roth IRA in the same ETF and holding it for 50 years has a very high likelihood of leaving the investor well ahead in the end. Of course, even a 50-year holding period is not a guarantee of profit, but this is a case where I would argue that the ETF is a speculation over a one-hour hold and an investment over a 50-year hold.