Speculation vs. Investing

Recently, a friend asked, “what do you think about gold?”

My answer?

“It can add extra diversification to your long-term investments and act as a hedge against inflation and uncertainty in the stock market. But I would only maintain a small percentage in the overall portfolio.”

This was not the answer he was looking for.

My friend was looking for my opinion on the price direction of gold due to current events in the world. He was trading gold and expected a big price move. I couldn’t offer an opinion on that.

Our conversation illustrates two different approaches to growing your money: investing and speculating. I was looking at gold through eyes of an investor. My friend, on the other hand, was looking at gold like a speculator. Understanding the difference will help you achieve your financial goals.

There are many different definitions of speculation. Generally, however, speculation is engaging in a financial transaction that has a considerable risk of losing its value with the hope of significant and above average return. Short-term trading, market timing, and holding a concentrated position in one investment are all considered speculation.

Meanwhile, investing involves less risk of your principal investment with the expectation of satisfactory or average returns. Investing takes into consideration a long-term time horizon, diversification, and an analysis of the fundamentals of the investment.

Let’s take a more in-depth look at how to tell if you’re investing or speculating. For this example, say you’re buying a stock.

What’s driving your decision to purchase this particular stock?

Are you buying it based on the fundamentals of the company? Will it be a part of a diversified portfolio of stocks? Or is it based on news headlines? Excitement because it’s a new IPO? Or did you maybe get a recommendation from a friend or co-worker?

The key difference between investing in a stock and speculating is your understanding of the company. Picking stocks is difficult. That’s why mutual funds are a preferred option for many investors. If you don’t have a solid understanding of the fundamentals of the company, then your stock picking can be described as speculation.

When you’re buying this stock, what sort of time period are you looking at? How long do you think it will take to grow your money?

Investing is for the long term. Investors are less concerned about the timing of the investment versus the expected return over the long run. Short-term trading is speculative. Trying to time the market is very difficult. You have a fifty-fifty chance of being right. You can lose your capital pretty fast trying to beat the market.

How much of your investable money are you putting into this one stock?

There’s an old saying: Don’t put all your eggs in one basket. The appeal of betting big on one position is simple. If you’re right, the return will be significant. I’m sure early investors in Apple wish they had bought more. But no matter how well you understand a company, you don’t know the future. History is filled with well-established companies losing their value. Look at Bear Stearns and Lehman Brothers, two long-standing investment banks that went under during the financial crisis of 2008. Who saw that coming?

Investing involves having a diversified portfolio, not being concentrated in one position. This way you are not overexposed to the potential negative events of one company. Speculating would be putting all — or a significant chunk — of your money into one company.

Speculating is not inherently bad. It just has significant risk. I speculate. I like to trade stock options, and I own Bitcoin, which is considered pretty risky. The key is not to engage in speculative transactions that put your financial wellbeing in jeopardy.

If you’re going to speculate, I recommend following these rules:

1. Make sure your important financial needs and objectives are met first. If you’re saving for a new car or a down payment on a house, make sure you have this money saved first. Are you on track to meet your long-term objectives like retirement or your kids’ education? If not, put money towards these objectives first. And most importantly, make sure you have an emergency fund set up.

2. Don’t speculate with the money you have for your important financial goals and objectives. Money for your short-term goals should remain in safe investments like a savings account, CDs, or a money market. Money for your long-term goals should be put in a diversified portfolio of stocks and bonds, preferably mutual funds or ETFs that will be held for the long term. No short-term trading should be done with this money.

3. Make sure you don’t have any debt. Any money you want to speculate with should be put towards paying off your outstanding debt, e.g. credit cards, student loans, and car loans. If you are in debt, don’t try to speculate your way out of it.

4. Most importantly, do not use borrowed money to speculate. In a brokerage account, you have the option to buy certain stocks on margin. Be very careful here. When you use margin to buy a stock, you’re paying for part of the purchase with borrowed money. The danger is if the investment goes down too far in value. When you buy on margin, you’re required to maintain a certain amount of equity in the account. If the value of your stock goes down too far, you can expect a margin call. This means you need to add more money to the account or be forced to sell a portion of your investment at a loss. If things go really bad, you could end up with a negative balance in your account and owe your brokerage company money. I have seen this happen on more than one occasion.

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