Investing entails the acceptance of risk in the pursuit of a worthwhile return. Speculation involves the same thing, and that commonality often leads people to confuse investing and speculation. In fact though, they are very different things, and if you are to become a successful investor, it is important to be able to distinguish the two.
Investing vs. speculation
Here are some of the things that distinguish investing from speculation:
1. In-depth information
Successful investors thoroughly research their targets, whether they be companies, government bond issues, or commodities. They understand the supply and demand dynamics that will drive market growth, and they understand the competitive forces and cost factors that will determine the ability to profit from that growth.
Speculators, on the other hand, don't look in depth at the underlying vehicle, but simply put their money on a belief that it will go up or down.
2. A detailed outlook on the future
Understanding current conditions is good, but a further step entails being able to make some calculations about how those conditions will develop in the months and years ahead. This may take the form of things like a multi-year earnings projection for a stock, or quantifying the interest rate sensitivity of a bond.
You need to have thought through both what you expect to happen and how your investment will react if you are right. Without specifying how you will succeed, you are just speculating that things will work out in your favor.
3. Consider valuation
Taking into account valuation is a critical component of investing. It means comparing the price now with the likely future value of the investment based on its underlying fundamentals. This is critical, because markets often anticipate the future. If what you pay for an investment already reflects an assumption of its future success, there will be little upside for you even if things go in your favor.
On the other hand, speculators just hope that if things go well, the price will go up.
4. A flexible time frame
True investments can take some time to succeed - economic fundamentals usually evolve gradually, and sometimes it takes markets a while to recognize value. Having the flexibility to wait for all of this to play out increases your chance of success. In contrast, narrowing down the time frame in which it can happen takes you down the road towards guesswork.
5. An awareness of a differing perspective
Understanding how your view of an investment differs from the market consensus is very important, because if you don't see things differently, there is less potential for you to profit. This is why buying into highly-popular investments takes on an increasing element of speculation. You haven't really thought through why the investment should go up any further, you just like what everybody else likes.
Your differing perspective can involve any or all of the things discussed above: the information you have, your outlook on the future, valuation, or the time frame over which you are willing to hold onto the investment.
6. Recognition of the downside
Speculators tend to be focused primarily on the rewards of winning. But a true investor also understands the probability and downside potential of being wrong.
7. Extent of reliance on others
The "greater fool theory" means that you don't care if you overpay for an investment, because if it keeps going up a greater fool will come along and pay you more for it. Depending on the irrationality of others rather than on investment fundamentals is one of the hallmarks of speculation.
Investing vs. safekeeping
Though true investing should be less of a risky proposition than speculation, it is important to understand the distinction between investing and safekeeping. Investing involves being conscious of the risk of loss, and trying to manage it in proportion with the potential upside. Safekeeping involves eliminating the risk of loss, at the expense of any real upside.
For example, savings accounts and other insured deposits should be fully protected against loss, but they offer little in the way of upside - especially when interest rates are low. However, if safekeeping is what you want, it is important to recognize that as your priority and ensure that your money is placed accordingly. This means making sure you stay within FDIC insurance limits, and not mistaking truly safe vehicles for somewhat low-risk investments, like government bonds for example, which still carry some risk of loss.
The distinction between investing and safekeeping is in the trade-off between potential upside and potential loss. The distinction between investing and speculation is essentially the difference between making a reasoned business decision and placing a bet.
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