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Speculation vs Investment

Speculation vs Investment

Feb 18 2021

Investment is more accessible today than ever before, largely thanks to DIY investment platforms that allow people to try their hand at managing and growing their own wealth. Anything that boosts investment is inherently good for the economy, but it has also meant that Kiwis are investing without advice, now more than ever. As a result, many inexperienced investors lack the foundational knowledge to understand whether they’re actually investing or speculating. This can lead them to take on excessive risks, leading to unmanageable losses that put their livelihoods on the line. Understanding both investment and speculation – or working with an expert who does – is key to managing your financial risk and to ensure that your wealth-building strategy is viable in the long term.

Anyone who buys or sells securities is commonly considered an investor, and this can lead to some confusion when it comes to distinguishing between the concepts of investment and speculation. After all, both involve using similar tools to allocate money with the expectation of some future return. The difference arises in the manner in which funds are allocated, how risk is managed, and how investment decisions are made. While investment prioritises risk-adjusted returns, speculation prioritises profit. Investment tends to have a long-term outlook while speculation centers around the short term.

An important distinction

The most critical difference between investment and speculation for new investors is their approach to risk management. Good investment involves a strong focus on achieving a reasonable rate of return while protecting wealth while speculation is about recognising and seizing opportunities for shorter term (and hopefully large) profit. Benjamin Graham’s definitive work on value investing, “Intelligent Investor”, describes the difference between investment and speculation as follows:

“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Speculators accept greater risk in order to pursue the greater opportunity. Accepting risk, however, doesn’t always mean being fully informed and being aware of the size of the risk being taken. It’s entirely possible for someone to speculate when they think they’re investing because they haven’t done sound research. Being unable to differentiate between investment and speculation means, in effect, failing to properly understand and manage the risk inherent to your wealth management strategy. By being intentional about the amount of speculation we engage in versus investment, we can limit risk and potential losses while sustainably growing wealth.

Speculation can lead to excessive volatility

Speculation is often focused on market trends and growth potential. This means that the speculator isn’t necessarily focused on the viability of the business behind a particular share or the price being paid for it. Speculators often take cues from the market itself, meaning that they might buy a particular share to capitalise on a growth trend – effectively gambling that it will continue. As more speculators jump on the bandwagon, the price continues to inflate, creating a bubble.

Later, once the share is too obviously overvalued, speculators begin to sell. Others, seeing an end to the growth trend, also offload their shares in order to minimise their losses, causing a crash. This is ultimately the cause of volatility, where share prices swing in ways that don’t reflect the real asset value of a company and create further opportunities for speculators. Investors with a low tolerance for risk will instead avoid volatile shares due to this same unpredictability.

Speculation is not limited to just shares. It can involve any asset: crypto-currency, houses, gold. Fads in things like olives, ostriches and deer also come to mind!

The key to good investing

Speculation is just as risky as it sounds, but that doesn’t make it inherently bad or wrong. Investing in common shares, according to Graham, almost always requires the investor to recognise some speculative factor in their holdings. Inherently there is more risk in owning one or a handful of shares than in ‘owning the market’. An individual company can go broke and disappear. The market never disappears. What’s more it tends to rise in value over time.

Rather than avoiding all speculation, it is the investor’s responsibility to understand the difference, and to be fully aware of when and how they are speculating. This helps them to balance the opportunity against the risk they take on in a way that they’re comfortable with.

Investment, in contrast to speculation, is fundamentally based on a conservative mindset. The primary goal is to preserve the principal, profitable returns come second. This ensures that the investor’s wealth has a reasonable potential for growth, even if it does so slowly.

The biggest danger with speculation is thinking that you are investing when you are actually speculating. For example, startup investing can be immensely profitable, but it typically also involves a great deal of risk. An informed speculator might invest in a venture like this, but would never commit more funds than they could afford to lose. For some, speculating can result in ruinous losses.

In order to speculate safely, it’s important to limit the amount of funds put at risk, and to cultivate the necessary knowledge and skill for it.

Our view

DIY investment platforms have made investment more accessible but they haven't made it safer. While more investment, speculative or not, is a benefit to the economy as a whole, it’s important for new investors to understand enough about securities trading to protect their own interests. This means, in particular, having a firm grasp on the difference between investment and speculation.

Speculators don’t necessarily make decisions based on sound research, and many speculators aren’t aware that they are speculating in the first place. That’s why we at Trustees Executors recommend new investors seek information and advice before investing, and to be very deliberate about what type of investor they want to be. Working with a qualified financial adviser can help you understand your appetite for investing and help you with information and goal setting.

Investing isn’t just a way of protecting and growing our wealth, it’s also the foundation on which economic growth is built. Because of this, enabling as many people as possible to invest is a great thing for the economy, and everyone who is active in it. We want to ensure that amateur and prospective future investors have the information and the support they need to make good decisions that provide the best possible outcomes for them.

Are you new to investing, or looking for financial advice to help you build a secure wealth building strategy? Reach out to us today for an initial discussion with one of our Private Wealth advisers. Any such conversation is at our cost, confidential and without obligation.