The Difference Between Investment and Speculation

There are very few concepts that define more clearly the path to long lasting wealth than understanding the difference between investment and speculation.  Out in the real world, most high-income earners and investing novices often mistake these two principles.  While I have been involved with my share of speculative markets, the main reason I fired my financial advisor was that I didn’t always feel like he understood the difference between the two.

While there is definite room for speculation in almost any asset allocation, investment should be where the majority of wealth is stored and allowed to grow.

So what are some of the defining characteristics that show the difference between investment and speculation?

Let’s take a closer look.

Time vs Luck

Investments grow over time.  The fundamental premise is that the fund, stock, bond, business, or real estate venture has measurable value.  That value is expected to increase as the years pass such that it will be worth more in inflation adjusted dollars than when it was purchased.  The value can take many forms.  Not only appreciation, but also cash flow from a property or dividends paid from stock.

Although work may be involved as with building a business, it may not be necessary as in holding a mutual fund.

Either way, the passage of time and compounding do a major part, if not all the heavy lifting.

The difference between investment and speculation is that speculation relies mostly on luck.  Time may or may not be beneficial.  There are a few types of luck.  One is that you purchased an asset below market and can sell it immediately for a gain.  Another is that you bought an asset at fair market value and can convince someone to buy it for more than it is currently worth.  Lastly, you bought an asset and an unexpected occurrence caused an increase in value.

Risk managers vs Risk takers

So after reading the last paragraph, I’m sure savvy readers are wondering how one differentiates a speculative venture versus an investment.  The answer, of course, is all about risk management.

Investors are risk managers.  They mitigate risk by hedging their bets.  Often they are leery of putting money down until they are pretty sure of a successful outcome.  They invest in stocks and businesses they understand, they perform due diligence, and they monitor their assets carefully.

Examples abound.

Putting money in an S&P 500 index is an investment.  Based on the endurance of the American economy,  past performance, and the adjustable nature of the index, it is likely that over extended periods of time the value will multiply.

Buying a stock that your brother-in-law suggests in a startup company with no profits is speculation.  Especially if you have no knowledge of the industry, the company has yet to prove itself, and there is no measurable business plan.

Buying a multiunit building in a well-established neighborhood that easily meets the 1% rule, cash flows nicely, has a good cap rate, and can be held for decades is an investment.  Leveraging oneself heavily in an upcoming “hot” neighborhood for a multi-unit building that has cash flow problems in hopes that it will appreciate and get sold in a year for large profits is speculation.

It is notable that even speculative ventures can and do sometimes produce large profits.  But they also produce large losses.  The difference is often luck.

Are your risk taker or a risk manager?

Efficiency vs Inefficiency

The difference between investment and speculation often boils down to market efficiency.  For the most part, investors rarely try to exploit market inefficiencies.  They pay for the value of an asset that they feel is going to grow, and then they allow time to do the work for them.

Speculators love market inefficiency.  They want to buy low and sell high.  Or buy high and sell higher.  The innate value of an asset or its growth projections is not nearly as important as how quickly they can take advantage of a mismatch between price and value.

Final Thoughts

Investors are risk managers who use their knowledge, risk mitigation strategies, and time to profit from an efficient market.  Speculators are risk takers who pray for market inefficiencies and hope luck will go their way.

If you want to get rich quick, by all means,  go ahead and speculate.  Be aware though that with high risk comes the possibility of devastating losses.

If you want to be an investor and manage risk, kick your feet up.

It’s going to take some time.

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