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.
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!