So, let’s begin. What is the definition of investing? What is the definition of speculation?
Robert Hagstrom, CFA. This was previously published on Inside Investing at the CFA Institute.
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About Robert Hagstrom, CFA
Robert Hagstrom, CFA is Chief Investment Strategist at Legg Mason Investment Counsel and the author of the New York Times best-selling The Warren Buffet Way. He is also the author of The Warren Buffet Portfolio: Mastering the Power of the Focus Investment Strategy; The Essential Warren Buffett: Timeless Principles for the New Economy; NASCAR Way: The Business That Drives the Sport, andThe Detective and the Investor: Uncovering Investment Techniques from the Legendary Sleuths. Follow Robert on twitter here.
19 comments on “What Is the Difference between Investing and Speculation?”
To me, speculating has to do with the notion of buying something with the idea that you will trade it to someone else as soon as you can realize a favorable price , while investing would imply a willingness to own that something for an extended period of time without worrying much about the short run or temporary impairments of capital. It may also have something to do with how much work you have put into trying to understand the underlying/intrisic value of that something.
Warren Buffett, who was Graham’s best student, has a definition which I agree with. An investor is one who seeks return from the underlying asset itself, whether be earnings/dividends from the underlying company for a stock or rent from a property if it is real estate. A speculator on the other hand seek returns from pure price appreciation. Also in my opinion, an investor sees the stock as a business, while a speculator sees the stock as a ticker symbol. In the mind of an investor, he/she is owner of a sound and profitable business while in the mind of a speculator, he/she is playing a zero sum game trying to beat the other people in the market.
Future income from the asset is considered in the pricing. So that means speculators are also investors?
Berkshire Hathaway doesn’t pay a dividend and isn’t real estate. Most people buy BRK shares in the hope that their value will appreciate. Does that mean buying shares in BRK is speculation?
If I can be forgiven I like to use a poker metaphor to describe the difference between investing and speculation. For me investing is where you are dealt a good hand and slowly increase your stake as the hand improves, seeing how the other players react and how the cards are played, speculation is more a bluff, you are dealt a hand and you can take a guess at how good it may be but you cannot see any future cards, however, you bet large on the chance of a big win regardless of the uncertainty. A good poker player (investor) much like in the words of de la Vega, plays a mixture of the two, a mixture of risky bluffs and calculated less risky play.
This is perhaps the most important topic of out time. Many times, the value of the business diverges sharply from that of the market…witness the 2000 period dot com runup as an example. If you were the holder of a pension asset during the period, your interests will ill- served by money managers chasing an index so as not to underperform and lose clients. of course, the pension holder suffered greatly form those who indexed their funds in the subsequent period.
Another way of saying this is to look at vanguard- a firm which indexes for a living. look at their returns from 2000 and ask whether one wouldn’t have been better off in simple corporate bonds.
Investing vs. Speculating = Analysis vs. Guessing
The other comments had some great thoughts as well. Using time span to differentiate between investing and speculating does not capture the essence. Similarly, exiting a “trade position” after having achieved a target return in a short period of time, may not necessarily classify it as a speculative trade.
The difference is semantic. We’re all maximizing inter-temporal utility – the enormous degree of subjectivity introduced by attempting to objectively distinguish between investing and speculation makes the practice futile. They’re not diametrically opposed, but sit right next to each other on a continuum of acts wherein people sacrifice a certain amount of utility in one time period hoping to realize a greater amount of utility than would have otherwise been possible in another.
What connects a lifetime pension contributor who passively selects mutual/target date funds for his retirement and a guy looking to make his dreams come true by buying calls on tech stocks into Q1 earnings is stupidity. Or, to keep it general, an inter-temporal utility function subject to conditions that, when maximized, leads to behavior we might find ‘irrational.’
I see investing and speculating as “symmetrical” opposites of each other that share the same goal, namely, making a profit.
Investing contains a component of speculating, and speculating contains a component of investing. The main emphasis in investing is on the value of the assets underlying the investment with the expectation that it will create a desired return (i.e., profit), and less emphasis on the price fluctuations (which is the speculative component).
On the other hand, the main emphasis in speculating is on the price fluctuations with the expectation that it will create a desired return (i.e., profit), and less emphasis on the value of the assets.
Investing is the process of sacrificing the present value of a good (be it cash, time or some other type of asset) for it to multiply by the underlying growth of an ongoing or future opportunity (be it a project, a stock or asset) with solid economic fundamentals and approximately measurable risk obtained through thorough analysis and rational behavior. Therefore the risk/return objectives can objectively stated bounded by a time frame and can also be used for hedging. An investor can only go long to attain his specific risk/return objectives, if he goes short it is merely to hedge against unpredictable risk.
Speculation is also the sacrifice of the present value of an asset to obtain a benefit from the growth or losses (and loss is key) of an ongoing or future opportunity. Speculation can or cannot be based on solid fundamentals, thorough analysis and rational behavior. Speculation can have out sized returns or losses due to the uncertain nature of the underlying opportunity, it seeks to exploit volatility. Since short term volatility tends to be smoothed over time, speculation has a smaller time window. Speculation and hedging are also mutually exclusive, as Merton Miller stated “if you do not hedge you are a de facto speculator” which also reinstates that speculation mostly benefits from uncertainty.
“There are always three games going on in the market at any time: a game of chance, a game of skill and a game of strategy. Games of chance are gambling; games of skill are speculating; and games of strategy are investing. The best way to understand this is to look at the definitions. Investors, like Warren Buffett, want to find the underlying value of a company. The time horizon is the same time horizon it takes to work out the company’s strategic plan, usually years and decades. The speculator doesn’t care about the underlying value of the company. He cares about the underlying demand of buyers and sellers in the stock. He is looking at the beauty-contest aspect: will people like the stock and bid it up or not. And the gambler is just a more speculative speculator, making a bet because he’s got a hunch that he knows what’s going on.” (Alfred R. Berkeley)
For me, the difference between speculating and investing is affected by liquidty risk.
Focussing on the time frame or the intention takes attention away from a crucial and often forgotten part of the process: The need for someone to take you out of your transaction.
I think that if your plan involves eventually selling your asset to someone else, whether that is in 8 seconds or 30 years, then you are speculating, not investing.
If you need someone to “take you out” of a position in order to make a return, then you are exposed to liquidity risk i.e. the risk that the market may not be able to buy at the time you wish to sell, and vice versa.
This definition puts most stock market “investing” in the speculation category, since most people plan to exit their position by finding another monkey willing to buy it.
The persistent speculator is comprised of all those who have no usable information about what their appointed ‘investment’ advisor is being told to buy by another advisor, neither of whom knows, within any statistical fidelity, what they are doing. They operate on luck, confidence, and Hugo Boss. Those things disappear in that order, but usually they have feathered their nest, not by making a profit for themselves (and their clients) but by the sure and simple way of taking a commission. The only way to invest is to invest in yourself and your immediate family. That way has been lost to most, due to the discount people place on future consequences. It doesn’t matter how much money you have when it either disappears due to a ‘market correction’ that no one saw coming, or when it can no longer be exchanged for what you need, when you need it. One could go on and on, but I find it sufficient to say that no one knows what is going to happen in the future, and the farther one sttempts to speculate, the more chaotic are the predictions that any modelling used up to now have supplied. One thing appears to have held constant, and that is that human physiology hasn’t changed appreciably over humdreds of thousands of years, however, the last few generations have managed to confuse the investing of money with the investing of right action.
Ian MacLeod
I’m one of those people who looks at the question and has difficulty seeing any meaningful distinction. The distinction becomes especially blurry when you consider a casino owner.
It seems clear that owning a business like a casino is a long-term investment. But a casino owner’s profits in any given night come from the thousands of short-term speculations he engages in. The fact that the odds are in his favor make it seem less speculative. But then how is he any different from the speculative computer with the odds in its own favor that makes thousands of trades per day?
Liquidity is the key, in my opinion, to distingusihing between investment and speculation – the source of the liquidity.
If we are relying upon the contract and for example collecting the coupons and principal of a bond, the source of liquidity is the obligor under the contract. If we are relying upon sale of the asset in a market, this is speculation. We are, after all, uncertain that the market may exist or that the price will prove satisfactory.
This also delivers a time dimension and shades of grey between these – in general the longer we hold an asset the more income is non-market.
I have written a number of articles in the past year on this – happy to send them to anyone who would like to read them – drop me an email at:[email protected]