What’s the Difference: Speculating vs Investing
One of the biggest misconceptions I have noticed amongst novice investors is that that they are investing when their actions are often more clearly defined as speculating. These two words have different definitions but there is often enough gray area to muddy the waters on what you are doing in any specific instance.
You must understand the difference between speculating and investing if you want to hit your financial goals.
Investments are generally protected from dramatic losses, or even total loss, by sound financial principles that create a tangible value in what you are buying. Stocks in Apple give you a share of ownership in Apple that is backed by all of their cash in the bank, intellectual property, brand names and factories.
When speculating there are generally no sound finances to fall back on. Price is often dictated totally by demand. Demand can dry up seemingly overnight causing a sudden total loss of principal.
Webster defines investing as to commit (money) in order to earn a financial return. In general, you purchase a financial asset in the hopes that it will appreciate in value or that it will generate cash flows that are greater than your purchase price.
Stocks can pay dividends which are a share of the profits of the business. Your expectation is that over time these dividend payments pay you a return on your money that is greater which makes the investment worth it. The dividend may rise over time and could eventually pay you more annually than your purchase price of the stock!
Some stock’s don’t currently pay dividends because they are re-investing all of their profits back into the business to grow it. You might buy a growth stock under the expectation that the value of the stock will appreciate quickly as the company grows. The expectation is that the company will eventually start paying dividends which will more than make up for your delayed gratification.
One common theme on both types is that there is an expectation that investments are used by someone to create economic wealth. You are not blindly hoping for a spike in demand to cause the price to rise but are essentially lending money to another entity to create something of value and you expect a return on your investment.
Speculate is defined by Webster as assume a business risk in hope of gain especially : to buy or sell in expectation of profiting from market fluctuations. In other words, you are trying to time a market and take profit based on the market’s movement.
When you speculate you are buying a financial asset with the hope that it appreciates in value and that you can sell it at a profit. You are hoping that demand drives the price of the asset in the direction you want it to go.
Speculators are often chasing much larger returns than are typical from investments. Speculators generally take very high risk and can lose all of their principal. They generally don’t expect that the asset creates economic wealth with their money. They are generally less concerned with the fundamental value of an asset than the price fluctuations of the asset.
There can be some gray areas here which make it difficult in some cases to know whether a financial opportunity is better considered investing or speculating. It can be helpful to look at commonly considered examples of each.
Typical assets to invest in:
- Stocks, both dividend and growth stocks
- Real estate, commercial and residential
- Bonds, all types
Typical assets to speculate in:
- Cryptocurrencies such as Bitcoin
- Collectibles such as baseball cards
- Domain names
- Tulip bulbs (Yes, this is real, people invested massive fortunes in tulip bulbs)
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There is often overlap or gray area between speculating and investing. There can even be disagreement on what category a financial instrument really belongs. I have always found it helpful to decide if the purchase feels more like gambling or more like lending someone money to build something. This will often give you your answer.
While these two terms can be similar, it is important to understand that at some point financial assets stop being about investing an become speculation. Speculation typically involves high risk instruments that are not creating economic wealth and you are attempting to time a demand driven market.
True investments generally generate cash flows, either now or in the future, that will more than reimburse you for your purchase price.
Remember when evaluating financial assets, particularly new ones that you don’t understand, the difference between speculating and investing. Make sure that whatever you choose to put your money into aligns with the financial goals you have set for yourself.