The difference between investing and speculating

In this lesson on the difference between investing and speculating, we will cover the meaning of investing and speculating, and the difference between them with a complete analysis. In the previous lesson, we had discussed the difference between saving and investing.

To be a successful investor, you need to know what saving, investing, and speculating means and the difference between them. Most often, we use these terms interchangeably. Thus, understanding these terms will help you confirm your role, e.g., either you are a saver, an investor, or a speculator. Further, not understanding your role can create havoc in your financial life. The post will be a long one. However, it is worth reading to avoid financial loss and create wealth.

What Is Investing?

According to Lexico, investing means putting money in financial schemes, shares, property, or a commercial enterprise with an expectation of achieving a profit.

In simple words, when you are investing, it means you are buying an asset for the long term to earn a profit in interest, dividends, rent, or capital appreciation. A person who invests is called an investor. Investment products include bonds, shares of companies, properties, and commodities. For example, you get income from bonds. Similarly, you get both dividends and capital appreciation when you invest in shares. Further, real estate can also provide you a constant earning in the form of rental yields and capital appreciation. Investing in gold, silver, or other commodities also provides you capital appreciation.

Thus, investing is a long term game. By long term, I mean at least three years or more. It is like buying seeds from the market, plant it, water it, and take care of it until it becomes a big tree to hold fruits. As you can see here, the underlying asset has also changed. A seed has become a tree. However, a plant takes years to bear fruit on it and be able to feed you.

What Is Speculating?

According to Lexico, speculating means putting money in stocks, property, or other ventures in the hope of gain but with the risk of loss.

In simple words, we say someone is speculating; when they are buying an asset for a short term to take advantage of the price fluctuation. It comes with high risk. A person who speculates is called a speculator. Speculators have nothing to do with the value of an asset; they only stick with the price. Some assets that come under speculation are stocks, real estate, currencies, antiquesfine artcollectibles, and commodities. The list may surprise you, but it is true.

Antiques, fine arts, collectibles are traded in millions of dollars. That never means that they are not worth the price. However, the value of these things is not changed; only the sentiments of people change. It causes the price action.

Speculation is about buying seeds and selling it in another market where speculators get a better price or waiting for the right time to come so that they can sell it at an inflated price. A speculator also makes money in the short term but fails to get fruits.

The Difference Between Investing And Speculating

ParticularsInvestingSpeculating
Time-horizonLong termShort term 
Purpose Income plus growthOnly growth
Risk ModerateHigh
Risk-managementAware about the riskDon’t Care
LeverageNoYes
Return expectationModerateHigh
Basis of decisionAnalysis & ResearchNews, Market Sentiments etc. 
Stability of IncomeYesNo
AttitudeConservative and CautiousAggressive 
Tax and chargesLowHigh
LiquidityLowHigh
VoltalityLowHigh
A Comparison table – The differences between investing and Speculating

The Difference Between Investing And Speculating – A Complete Analysis

The above table tells the complete story. However, we will analyze all these differences one by one to understand it fully.

Time Horizon

As discussed previously, an investor takes a long call but a speculator, a short one. For example, Ultrafast Trading, also known as High-Frequency Trading, enables speculators to trade within milliseconds. It means a speculator buys and sells shares in less time than the blink of an eye. They try to make small profits throughout the day. Such type of speculation also happens in currencies and commodity market. The market conducting buying and selling currencies is called ‘The Forex Market.’

Similarly, there are two commodity stock exchanges; The National Commodity & Derivatives Exchange Limited (NCDEX) and The Multi Commodity Exchange of India Limited (MCX). You can trade a host of commodities from Cotton to Gold in these two exchanges. Finally, these exchanges help speculators to speculate and make money or lose it over a short period.

Purpose

The purpose of investing is both income and growth. However, speculators focus only on growth. Investors are aware of the fact that price appreciation or growth is not guaranteed. Therefore, they prefer to earn income from their investment. For example, when a person puts money in real estate, hoping that it will grow faster without any analysis and research, he speculates.

On the other hand, a person buys a dilapidated house, renovates it, rents it out, earns income, and expects a decent price appreciation of 8-12% over a long period. It is an investment. Moreover, growth can become stagnant for a long time or even go negative, particularly for real estate, but income from rent is not an illusion.

Risk

Risk is inherent both in investment and speculation. However, speculation is the riskier one. Some people advocate that more risk means more money, but always that is not true. For example, gambling in a casino of Los Vegas means taking a more significant risk to your capital. However, it never means you will get more money.

Further, the risk is a relative term and not an absolute one. Money is always at risk. Wherever you keep it, be it under the mattress, savings accounts, bonds, debentures, or even in a bank locker, it is risky. However, the degree of risk changes from one to another. For example, buying a debenture is risker than a bond.

Risk-Management

Investors know what they are doing. Thus, they take the necessary precautions to reduce the risk through diversification. Diversification means putting your money in different asset classes. For example, suppose an investor has one crore rupees to invest, and he wants to reduce the risk of capital loss. Then he divides the amount equally in five parts (20% allocation to each investment) and diversifies his investment in the following way.

  1. Fixed assets like bank FDs
  2. Mutual Funds
  3. Stocks
  4. Real Estate
  5. Commodities like Gold or Silver

Further, he can also diversify within an asset class. For example, in real estate, he can buy properties in different locations to reduce the risk. I know that it is impossible to diversify real estate in just 20 Lakhs, but it is just an example. However, risk management is not a piece of cake for speculators. Therefore, their speculated amount is not well diversified. It poses a massive risk to their capital. We will cover the topic of diversification in detail.

Leverage

According to Lexico, leverage means using borrowed money for an investment, expecting the profit made to be higher than the interest payable. Most investors use their own money while investing. However, it is not the case with speculators. They borrow money to make money. For example, forex trading institutes provide leverage up to 400 times. If you have Rs 1,00,000 in your trading account, you can leverage up to Rs 4,00,00,000. It is a double-edged sword and can go in both directions. Other leveraged products include Futures and Options. 

Return Expectation

Investors expect an average return in the long term, but speculators expect a high yield quickly. Investors know it is Ok to get 12-18% CAGR (Compound Annual Growth Rate) on their investment over a long period. Moreover, it is around double the rate of inflation. It is wise to get 5% more return than the rate of inflation. However, speculators try to maximize their profits by indulging themselves in more short term positions. They make money in one trade and lose money with others. Let’s take an example.

HDFC BANK Share Price History
HDFC BANK Share Price History Source: https://www.google.co.in/

It is the historical chart of HDFC BANK’s share price. The price of one share was just Rs 5.52 on 1st January 1999 (after bonus and spilt adjustments), and on 10th July 2020, its closing price was Rs 1106.65. It means a return of 28% CAGR or a 200x profit. I have not factored the dividends. If added, it can jump up to a whopping 30% CAGR. It means your initial investment of Rs 1,00,000 is worth of Rs 2 Crore today and a few lakh rupees as dividends. It is not the only example. Hundreds of Indian and Multi-National Companies have delivered stellar returns like this. However, I doubt anyone speculating on the same stocks would have made such a huge profit.

Basis of Investment Decision

Investors make investment decisions based on the principles of investment. They invest only after complete analysis and research. They also track and make necessary modifications annually during the portfolio rebalancing. Portfolio rebalancing means rebalancing your portfolio at regular intervals according to your asset allocation strategy. We will cover these topics also in our future lessons. However, most of the speculators are not aware of these essential financial concepts or don’t care about it. They put their money based on news, sentiments, or market trend. They take tips from friends, so-called financial experts, TV anchors, and speculate.

Stability Of Income

Investors get a more stable and predictable income than speculators. For example, a property investor gets rental income from his properties, and it is a predictable, steady, and regular income option. However, a person buying a piece of land hoping that he will double his initial capital in just 3-4 years due to high market demand may end up belly up. Today’s generation has found a lot of ways to satisfy their speculation attitude and make money fast. However, it is just like killing a hen to make money rather than depending on its eggs.

Attitude

The attitude of an investor is conservative and cautious. They know that there is always a risk of capital loss. However, the positions of speculators are careless and aggressive. They speculate until they lose all of their capital. Once they lose money, they become more aggressive in their approach only to get into trouble.

Charges and Transaction Costs

It is one of the most disadvantages of speculating. However, it favors investing. Once you start to buy and sell frequently, the tax-man takes a note of it, and you end up paying more in taxes. Similarly, brokers also charge a high transaction cost when you speculate. Therefore, they always want you to trade frequently. They also have families to feed. Most speculators do not deduct the charges and brokerages while calculating their profit or loss. However, it is a good practice to calculate your gain using the following formula.

Net Profit = [Gross Profit – Taxes – Brokerages – Duties – Other Charges]

However, investments are tax-friendly products. Investors don’t have to pay brokerages, taxes, and other associated costs as they don’t trade frequently.

Liquidity

When we say that an asset is liquid, we can redeem the capital invested quickly. For example, bank FD is more liquid than real estate. Most of the investment options are not liquid. However, there are a few exceptions, e.g., stocks and mutual funds, where you can quickly redeem your invested capital. Therefore, speculation wins in terms of liquidity as speculators trade frequently and don’t have to lock their money anywhere. It is one of the most significant advantages of speculating.

Volatility

Volatility refers to a rapid and unpredictable change in the price of financial products. The best example is stocks and mutual funds. However, you should note that every investment comes with a certain amount of volatility. In the historical chart of HDFC BANK, you will observe that the share price goes up and down frequently over a short period. During a live session, the share price changes with every second. Speculators try to take advantage of this price fluctuation while investors take a long call and drink lemonade on a beach.

“It’s in the nature of stock markets to go way down from time to time. There’s no system to avoid bad markets. You can’t do it unless you try to time the market, which is a seriously dumb thing to do. Conservative investing with steady savings without expecting miracles is the way to go,”

Charlie Munger – An American Investor & vice chairman of Berkshire Hathaway

A Closing Thought On The Difference Between Investing And Speculating

To know the difference between investing and speculating is the first thing you can do before you start your investment journey. As you have observed, speculation is not an alien word for us. We often speculate. It is a part of our life. However, it should take only a small piece of our experience and our capital also. I suggest you open two trading accounts—one for speculation and another for investment.

Further, restrict speculation to a maximum of 10% of your investable or invested capital. It will reduce the risk and also cater to your speculating attitude. Let’s end the lesson with a famous quote by Mark Twain on speculation.

“There are two times in a man’s life when he shouldn’t speculate: when he can afford to and when he can’t.”

— Mark Twain

I hope I have made things clear. I would like to hear from you in the form of comments, suggestions, or recommendations. You can also share the article with others in just a few clicks.

Thanks and regards,

finguru@finlessons.com

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2 thoughts on “The difference between investing and speculating”

  1. Valuable informations… I think speculating means trading where as investing means holding shares of companies after proper analysis.

    Reply
    • Yes. It’s correct. However, speculation is not limited to stock trading only. Its scope is more extensive. For example, one can speculate in gold, silver, real estate, fine arts, collectibles, IPOs, and a host of other things.
      Thank You.

      Reply

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