Are you Investing, speculating or gambling?
Anytime you discuss or analyse a decision that entails potential profits or losses under risk or uncertainty, it is fair to ask yourself whether you are investing, speculating, gambling or anything in between.
It is essential to recognise the rules of the game you are playing. What are the underlying stakes, the risks and the goals? What is the role of luck in it?
If you work toward investing as a strategy to build wealth and reach your goals, it is essential to understand the difference between investing, speculating, and gambling.
Investment is the employment of funds to acquire certain assets after due diligence for a mid to long period, with the objective of wealth creation and additional income in the future.
- Investing consists of opportunities that have a greater likelihood of being profitable.
- In the case of Capital Markets, Investing doesn’t necessarily mean that you expect to “beat the market”. However, it means you try to improve your portfolio over time.
- Instead of gaining more slices of the exact cake, you expect your portions to grow because “the cake grows” over time (the economy).
- The expectation of a return on income or price appreciation is the core premise of investing. In addition, there is an attempt to profit from the ownership of the underlying financial attributes embodied in the instrument, such as value addition, return on investment or dividends.
- Risk and return go hand-in-hand; low risk generally means low expected returns, while higher returns are usually accompanied by higher risk.
2) SPECULATING (trading)
Speculation is the employment of funds to acquire assets for a shorter time to take advantage of underlying asset price fluctuations.
- Speculating activities consist of opportunities where the investment outcome is highly uncertain.
- It entails purchasing assets (a commodity, real estate, etc.), hoping such assets will shortly become more valuable (price appreciation).
- Your only potential for making a profit is that someone else will be willing to pay more for an asset than you did, based on scarcity, increased demand or increased perceived value. Thus, speculating investments have a strong correlation with the greater fool theory.
- In such a case, investment is not determined by its fundamental value but by what someone else is willing to pay for it in the future. As such, speculation happens when there’s an extreme amount of froth in the markets, and investors are trying to ride a bubble before it bursts, hoping that someone else will buy from them at an ever-higher price.
- It’s hard to tell whether speculative assets (collectables, cryptocurrencies or even commodity futures) are overvalued because it’s challenging (some say it is impossible) to determine the asset’s intrinsic value or whether someone will pay more for it later.
- For some traders, speculation works as long as they have the nerves and data to help them crunch the numbers.
- The speculation involves taking a calculated risk with an uncertain outcome.
For CFA Ben Carlson from A Wealth of Commons Sense, we can look at speculation from a wider angle: “in my mind, you become a speculator when you start making decisions outside of a well-defined process or don’t have one, to begin with. If you have no plan, you are speculating. If you’re paralysed by fear every time the market goes down, and you don’t know what to do with your portfolio, that’s a form of speculation. Whenever I hear someone asks if they should be buying or selling stocks here, my initial reaction is that they probably don’t have an investment plan in place, and they’re more or less just winging it. Warren Buffett once said, “Risk comes from not knowing what you’re doing.” Having an investment plan and a systematic process mitigates this risk to a large degree. It doesn’t shield you from the risk of losses, but it does decrease the chances that you’re speculating with your life savings”.
- Financial editor Jason Zweig believes a huge difference exists between speculators and investors. Still, the financial media, including the Wall Street Journal, insists on using the word “investor” to describe anyone who transacts in securities. Here is his recent “rant” on the WSJ:
“The Wall Street Journal is wrong and has remained wrong for decades, about one of the most basic distinctions in finance. And I can’t stand it anymore. If you buy a stock purely because it’s gone up a lot, without doing any research on it whatsoever, you are not—as the Journal, and its editors bizarrely insist on calling you—an “investor.”
If you buy a cryptocurrency because, hey, that sounds like fun, you aren’t an investor either. Whenever you buy any financial asset because you have a hunch or just for kicks, or because somebody famous is hyping the heck out of it, or everybody else seems to be buying it too, you aren’t investing. You’re definitely a trader: someone who has just bought an asset. And you may be a speculator: someone who thinks other people will pay more for it than you did”. Jason Zweig thinks “calling traders and speculators “investors” shoves many newcomers farther down the slippery slope toward risks they shouldn’t take and losses they can’t afford. I fervently hope the Journal and its editors will finally stop using “investor” as the default term for anyone who makes a trade.”
As told by Robert Hagstrom in “Latticework: The New Investing“, Benjamin Graham once made this point: “The problem with our industry is not speculation per se; speculation has always been a part of the market and always will be. As professionals, our failure is our continuing inability to distinguish between investment and speculation. If professionals can’t make that distinction, how can individual investors? Graham warned that the greatest danger investors face is acquiring speculative habits without realising they have done so. Then they will end up with a speculator’s return — not a wise move for someone’s life savings”.
Gambling can be defined as the employment of funds for entertainment, while the chances of return depend upon the probability of a particular situation or event.
- You gamble anytime you bet money on an uncertain event and heavily involve chance/luck to win more money.
- The expected return for gambling harms the player, even though some people may get lucky and win. The probability is against you; statistically, the house always wins by a large degree (depending on the game).
- Gambling should be considered an expensive entertainment rather than a tool for wealth creation. But unfortunately – some analysts point out- it is just “an extra tax on the fools”.
4) SPECULATING VS GAMBLING
Although the two concepts may have some superficial similarities, a strict definition of speculation and gambling reveals the principle differences.
- Speculation is a financial transaction with a substantial risk of losing value and expects a significant gain. However, the risk of loss is more than offset by the possibility of a significant gain, even though that gain may never manifest.
- Gambling, on the other hand, always involves a negative expected return. Converse to speculation, gambling purely consists of a game of chance. Generally, the odds are stacked against gamblers. When gambling, the probability of losing is usually higher than the likelihood of winning.
- Compared to speculation, gambling has a higher risk of losing the investment.
- Gambling in the financial markets is often evident in people who do it mainly for the emotional high they receive from the markets’ excitement and action. Such a passionate attitude to create profits rather than trading in a systematic system indicates the person is gambling in the markets and is unlikely to succeed throughout many trades.
5) INVESTING VS GAMBLING
Something that might usually be considered an investment could be a gamble. Let’s look at the similarities and differences between them.
- Investing and gambling both involve risking capital to make a profit.
- In gambling and investing, a fundamental principle is to minimise risk while maximising reward.
- Gamblers have fewer ways to mitigate losses than investors do.
- Unlike investing, gambling looks at opportunities that have a greater likelihood of losing money.
- Investors have more sources of relevant information than gamblers do.
- Odds will favour the investor because he does not play a zero-sum game. The economy, over time, grows and creates wealth; the investor owns part of it. On the other hand, the gambler does not own anything and plays a zero-sum game where the house always wins.
- The investment discipline of answering specific questions about an investment opportunity will help ensure we aren’t gambling due to our lack of knowledge.”
- When you gamble, you own nothing, but when you invest in a stock, you own a share of the underlying company; in fact, some companies reimburse you for your ownership in the form of stock dividends.
Ultimately, my take is that you can choose any type of financial transaction available in the market as long as you know if you are investing, speculating or gambling.
I believe gambling is a tax on boredom that can destroy your financial and mental health; I would not suggest it to anyone. Speculation still holds some investing elements; however, I don’t extensively practice it because it requires a different investment “spirit”. I would rather focus on a passive investment approach: long-term ownership of well-diversified investments (real estate, bonds and equity investments). As Warren Buffett’s once stated:
“I will not trade even a night’s sleep for the chance of extra profits”.
Until next time, Sweat Your Assets.