How do we know when we’re investing—or speculating but thinking we’re investing? It’s not always obvious.
One of the factors that can make it difficult to know the difference between investing and speculating is that both produce gains and losses. Some sound investment strategies can turn losses for a few years, while speculating rakes in high returns just long enough to earn some credibility.
Since the lines between investing and speculating can often be blurry how do you spot the difference between the two?
The Quick Killing
Part and parcel of speculating is the quick killing–the chance to make big money fast. It may be the single factor that most separates investors and speculators.
The speculator welcomes the potential for the quick killing, in fact his whole “investment strategy” may center on it. Find a stock or two that will double, triple or even rocket to the moon in a few weeks or months. Once it has, sell at a huge profit, then move on to the next stock. The problem with this approach is that not only can it produce large gains, but it can also generate losses—big ones. But a true speculator may see losses, even big ones, as part of the cost of making the quick killing.
With true investing, limiting losses—especially big ones—is every bit as important as finding winning investments. An investor might shy away from anything that looks like a quick killing because he knows that making money through investing is tough enough, but overcoming losses is harder still.
Investing involves the long view, sometimes known as “patient capital”. Gains and losses will vary from year to year, so the emphasis needs to be on multi-year performance. That requires positioning not only in the right investments, but also in the right mix of investments that will be likely to perform over the long haul.
The investor buys right, then sits and waits for his investments to payoff. The results of an average return of 8-10% per year can be more profitable—and easier on the emotions—than a strategy of up 25% one year, down 30% the next.
Speculating is often an in-and-out process. The speculator is a trader, moving quickly in and out of investments as trends and opportunities dictate. It could be said that where the investor acts, the speculator re-acts.
Investing involves building a portfolio of mutually exclusive investments centered on the question “what if?” As in what if I’m wrong? The speculator is sure he won’t be wrong, and doesn’t bother to diversify. The investor never assumes as much certainty—and protects himself by diversifying his portfolio.
Investing means never having too much money tied up in a single investment or investment class, as a way of protecting from sudden reversals. Even if stocks are doing well, the investor still has a substantial percentage of his money in cash equivalents and bonds.
The speculator, always looking to maximize potential returns, is more likely to see diversification as a reduction in the amount of capital available for speculative investments.
Buying value versus buying into trends
Speculating often involves betting on trends. If energy stocks have been rising for the past few years then that’s where you put the majority of your money. And you stay in that sector until a similar trend emerges in another.
The problem with trends is that once they reverse, losses can be sharp and relentless. If those reversals are part of a general market trend, the speculator may be stuck riding the market down. The effect however may be greater because stocks that rise the most in rising market usually fall the hardest in a slide. The speculator may lose most or even all his money, forcing him to rebuild his capital base for another try.
The investor knows how fickle trends can be and concentrates his capital on value instead. He looks for stocks that have above average growth trends, a steady track record on profits and are strong performers in their industry. He may also seek companies that are undervalued—otherwise solid businesses with relatively low stock prices, often for no other reason than that they aren’t favored by the trend du jour.
Because of the emphasis on the underlying value of the companies behind the stocks he buys, the investor isn’t as subject to market swings the way the speculator is. In this way, the investor is likely to have much higher long term returns on the money he invests.
Creating real value versus raw speculation
Investing seeks consistent cash flows, and that can only come from businesses and industries that create real value in the economy. The investor looks for companies with successful track records as leaders and innovators in their industries, the kind of businesses that are likely to survive and thrive even in uncertain times.
Speculating seeks to make more money—where it comes from usually isn’t a factor. This opens the door to betting on upstart companies, new industries, crisis plays, future price increases or takeover rumors. All of these are pure gambling because they’re either based on events that haven’t yet happened or on businesses with no established track record. We can call that buy-and-hope! And it can either win big—or lose big.
Is all speculating bad?
All of us probably have a little bit of a speculator inside of us waiting to get out, and that’s not necessarily a bad thing. There may even be times when it’s worth letting our inner-speculator loose!
If you do decide to take a chance with your money—to take a gamble on something you “feel” but can’t justify objectively—just keep a few rules in mind…
- Never gamble with money you can’t afford to lose
- Make sure you have a solid mix of cash equivalents, bonds and investment quality stocks and mutual funds as the vast majority of your investment portfolio
- Keep the speculating percentage of your portfolio in the low single digits—if the gamble is a success, it might return several times your investment, but if it flops you’ll only be out a little
- Don’t do it too often—there’s a saying in the investment world, bulls make money, and bears make money—but traders go broke!
I think one of the biggest hurdles that must be overcome whether investing or speculating is money management and dealing with losses. Long term diversified investors can lose 40% of capital in a year. Just ask the indexers in 2008. It can take a while to come back from that type of loss.
It is a fine line isn’t it? When I started investing in the market, I think I was doing more speculating than investing. Once I made a stock purchase, I started checking on that stock every hour! If it jumped up, I was going to sell for sure. While I did ok with this, it was not the way to invest.
Investing should be done with long-term goals in mind. You have to ride the ups and downs of the market for a while before any true money can be made. If you’re not prepared to leave your money in the market for at least 5 years, then you should just stay out.
There are times when it’s a fine line. But as you say, what your long-term outlook is can tell you which of the two you are doing.
You start speculating if your investment horizon is short. Speculators overlook the power and potential of compounding growth for a ‘quick killing’!
That’s why I think losing money early on is a good thing. The distinction becomes clear!
I’ve talked about fantasy baseball and personal finance before but I think it bears repeating: You can’t do well in fantasy baseball if you are dropping and picking up most of your players all the time. A few players yes, but the others you drafted for a reason – because you knew they had long-term value. When a player hits a slump you ride it out if you know they have a great track record.
Analogy is spot on!
Generally would you say when most people look to start investing they start off as speculator? Not realizing that it not is the most the most profitable way to invest? If so I’d say a big difference between the two would be experience and knowledge. It seems as though a speculator invests to feed the gamble inside them to hit the grand slam.
A prime example of speculator vs investor would be in the show Shark Tank, for anyone that watches it, you see Jeff Foxworthy look for the grand slam investments while the others are very careful in what they do. They invest if they have a feel for the market and ask several important questions. Interesting and informative blog.
Mr. Frugal says
I agree that anyone that expects to jump in and out of the market, focusing on maximizing profits is a gambler. This isn’t what successful professional speculators, do.
I’m not a professional trader, never have been. I have been really diving in to learn about the craft for a while now. Here’s what I’ve learned.
Successful speculators focus on limiting losses first and foremost. Rule #1 is to cut your losses short and let your profits run. If you can manage your losses, the profits will take care of themselves.
I’ve heard numerous times that even the very best speculators are right only 60-70% of the time. They make money by taking small losses while letting their profits run.
Speculation is about risk management, not about gambling.
Risk management takes many forms, of which diversification is one. I would also like to point out that diversification takes many forms. You can diversify across time, industry or market sector as well as by just picking different stocks.
Hedging is another form of diversification.
Option trading can be a great way to manage risk because with several strategies (such as butterflies) your maximum loss is capped, and you can set it to whatever you’re comfortable with before you buy. Your risk/reward ratio is known before you enter the trade. And if you’re really savvy with your understanding of options, you can limit your risk to very, very small amounts of capital.
Risk management is what allows race car drivers to survive crashes, surgeons to perform brain surgery, astronauts to travel safely to and from space. Those activities would be insane to attempt without major risk management in place.
Speculating on stocks without three elements, from what I read, and which I also believe, is crazy:
1) Have a plan. Before you enter a trade, know where you want to get in and know when you’ll get out. You can’t just hope that the market will sweep you along into riches. There are thousands of other traders in the market and they all want to take your money (more so in some markets that in others). If you can’t see a reasonably high-probability scenario developing which gives you an opportunity to make a profit, don’t put your money into the market.
2) Have a risk management strategy. You wouldn’t drive without a seat belt. You wouldn’t ride a motorcycle without a helmet. You wouldn’t fly on a plane piloted by a guy who got his pilot’s license through an online course. Trading and investing is a high stakes game where you’re more likely to lose than to win if you aren’t able to limit your losses while letting your profits accumulate. Van Tharp write about trading using R multiples (reward multiples in relation to risk, basically the risk/reward ration. you might find it interesting).
3) Have an edge. If you’re just putting your money into the market and hoping for the best, you’d be better just taking your money out right now because you have no reason to be confident that the market is going to go in any particular direction (up, down or sideways). Your edge can be your ability to pick better companies, it can be knowledge of commercial interest in a given market through the use of the commitment of traders report (look it up, it’s worth at least knowing about), it can be super-fast computers which allow you to get into and out of the market faster than anyone else. Whatever it is, it has to be tangible and it has to be durable. Just thinking you have an edge doesn’t make it so.
Gambling in casinos is gambling because the house always has a significant edge against you. The edge is different in different games. In roulette your odds diminish the more you play. Your best strategy for playing roulette is to bet everything on red or black and win or lose, walk away. The more you play, the more likely you are to lose your money.
Blackjack is different though. If you really know what you’re doing, you can get a 1-2% edge over the house. With that edge, the longer you play the more money you will make, provided you can keep your losses small.
Value investing approaches like the CANSLIM method are great if they suit your personality. Some people are better suited for shorter-term approaches.
I don’t think it really matters too much which approach you take as long as you have an entry and exit plan on every transaction, a tangible and durable edge and a risk management strategy. And, it goes without saying that you have to have the ability to allow these factors work for you. If you start second guessing yourself or start changing things into a more discretionary system, then I think you’re probably destined for failure. Strong psychology underlies success in trading and investing as it does in basically every other profession.
But that’s just my $0.02.
Glen Craig says
Just your $0.02?!? You’ve got at least $2 in thoughts there! Haha.
One thing I found interesting in what you are saying:
“Risk management is what allows race car drivers to survive crashes, surgeons to perform brain surgery, astronauts to travel safely to and from space. Those activities would be insane to attempt without major risk management in place.”
The common thread here is that these people have EXPERIENCE.
The more you work at and learn about something the better you get at it. This allows you to make riskier moves that less experiences people can’t make. Or to be more correct, what seems like a riskier move to someone with less experience actually isn’t that risky for someone with experience and knowledge.
The more you learn about investing the better you get at it, like anything else.
Mr. Frugal says
Great point Glen!
I definitely agree that experience is a major factor. There’s no question about that. You have to understand how things work if you want to speculate about how they will behave in the future. So I think you’re definitely right about that.
I like the defensive driving paradigm. When I drive around town I’m not so concerned that I will do something to cause an accident. I’m more focused on what other drivers are doing around me that might cause an accident. The more experience I have as driver, the more aware I am about what might happen.
As a race car driver you have to be aware of yourself and your own car. And you have to be aware of all the other cars on the track as well. You never know what’s going to happen. So regardless of your experience level, you still need risk management (i.e. a roll cage, fire retardent racing suit and helmet) to keep you safe.
I think with experience you learn how important risk management is.