Investing vs Speculating - Are they the same?
It's common to find many traders in the financial markets who aren’t clear about the difference between investing vs speculating or who start out as investors and end up as speculators without being aware of it.
When we decide to invest capital into the markets to try to obtain returns, we must be clear about our objective because the path will be different for an investor and for a trader.
In this article, I’m going to cover some key points:
- What is investing?
- What is speculation?
- Advantages and disadvantages
- Which one is best for you?
Investing vs Speculating - What is investing?
If we look up the word ‘invest’ in the dictionary, we find that it means to use a certain amount of money in a specific project, a business or a financial instrument, to try to obtain profits. The ultimate goal may be to achieve recurring income or a one-time profit.
Although, many times, the line between investment vs speculation is very fine, the truth is that when we talk about investing we refer to its most traditional sense: investing in stocks or funds. We invest in something that we consider to have value.
In this sense, when we talk about investing in financial markets, there are two key decisions in the process:
✅ How much capital am I going to dedicate?
✅ What am I going to use it for?
To make these two decisions, we must make a very exhaustive analysis, first of our finances and, second, of the possible objectives of our investment. In this sense, we can follow some of the keys that the famous Benjamin Graham raises in his book "The Intelligent Investor". These are some of them:
1️⃣ Know well what we invest in, do a thorough analysis: the sector, the competition, the solvency of the company we are analyzing, its profit margin and its expectations.
2️⃣ Safety margin. This term refers to the relationship between the share price and its intrinsic value, based on fundamental factors. The lower the price of an asset, the higher the margin of safety, Graham argues.
3️⃣ Performance. The return will come when the market realizes the true value of the asset, so the investment is always linked to the long term. We’ll see this later.
Graham's theses, much longer than what we present in this article, have been the inspiration of many great investors, including the most famous of them all, Warren Buffett, the 'Oracle of Omaha'.
What is speculation?
What does speculation mean? When we speak of speculation, we refer to the purchase or sale of a financial asset whose price we anticipate will rise or fall in the not too distant future. Speculation is a riskier practice because you try to take advantage of short-term price fluctuations. Speculative trading uses both technical and fundamental analysis, but being short-term trading, technical indicators are often decisive.
When answering the question, “what does speculative mean?”, in practice, we can speculate on the price of almost any financial instrument, not just the traditional ones, as in the case of investing.
Contrary to what may be believed, the decisions of speculators are not the result of chance, but exhaustive technical analysis and, above all, of deep training. Admiral Markets UK Ltd. has trading training programs taught by professionals of all experience levels. If you want to attend any of our free webinars, just click on the following banner and register for the ones that best suit your needs:
To help us fully understand the speculating meaning, let's look at some examples of speculative trading:
Day trading is a common example of speculative trading. Day traders don't always have a specific set of qualifications. Often, day traders are given this label simply because they trade frequently. Mostly, they keep their trades for a day and close them when they are finished with their trading session.
A swing trader, however, stays in their trade for a couple of weeks, aiming to earn a profit over that time. To do this, the analysis is quite typical: a swing trader tries to determine the direction of a stock's price, enter a position, and make a profit when they exit.
It's now time to look at some of the specific instruments and strategies speculative trading involves:
Speculative traders often utilize many trades, including:
- Put & Call Options: With a put option, the trader can sell any portion of the security at a determined time and agreed price, but this is not an obligation. However, in a call option, the trader can purchase the underlying asset at a specific price before the contract expires.
- Futures Contracts: Two parties agree to the exchange of an asset at a specific future point in time at an agreed-upon price. The person buying completes the purchase of the underlying asset when the contract ends. Futures contracts are commonly traded on many exchanges and are often used in commodities trading.
- Short Selling: In a short sell, a trader has determined that the price of a stock is going to drop and takes a position and earns a profit off the falling of the stock price.
Strategies popular among speculators include the following:
With a stop loss, a trader sets a specific price limit at which the broker should buy or sell the stock. If a stock's price falls, the trader will automatically be exited from their position once the price hits their stop loss level, preventing them from losing more as the stock price continues to fall. With this, traders minimize losses.
Pattern trading involves identifying trends to find opportunities. Detecting trends is a part of technical analysis. Traders look at the past performance of a stock's price to predict its future direction. This feat is very challenging.
We can divide the differences between investing and speculating into four blocks:
|Investing||Generally, the investor keeps the assets in his portfolio for a long time - years or even their whole life|
|Speculating||Speculators often change assets in the short term, in a matter of minutes, hours, or a few days|
|Investing||Meticulous analysis of fundamental factors, including company ratios, competitive and industry conditions, and technical factors throughout the asset's history|
|Speculating||Mainly technical analysis, combined with fundamental and market sentiment|
|Investing||The main objective of the investor is to achieve small recurring returns in the long term, such as the payment of dividends|
|Speculating||The speculator seeks to achieve small profits in the short term|
|Investing||Moderate risk. The lower the risk, the lower the profitability|
|Speculating||High risk. The higher the risk, the higher the potential gains|
Despite these notable differences, both practices share very common mistakes.
- Going from investing to speculating without realizing it. For example, we buy shares in a company after doing a careful analysis but soon its price falls and we sell at a cheaper price than we initially paid. We then buy another uptrend stock at that time. We have gone from investing to speculating. This has a lot to do with psychological factors, such as impatience.
- Lack of knowledge. There are people who begin investing or speculative investment with the idea that the movement of the markets is the result of chance. This causes a lot of loss and frustration.
Advantages and disadvantages
The advantages and disadvantages of investing vs speculating are specific. These points will also help you decide which route is best for you. I discuss this in more detail, later.
Greater range of financial assets available
Less capital needed for leverage
Easy access to markets
Which one is best for you - investing or speculating?
Speculating and investing both entail risk. In both practices, traders and investors aim to profit from their positions. The degree of risk that each practice entails is the primary difference between investing vs speculating.
When someone spends funds on something with the aim of returning a profit off the endeavour, this is investing. In this undertaking, the decision making process is based on reasonable judgment formed by thorough analysis of the stock to determine if the endeavour will have a high probability of success.
However, what about when this undertaking entails potential profits, but a great amount of risk as well as a substantial probability of failing? This is speculation. In this case, success and failure usually depend on chance, or external, uncontrollable events and forces.
The main difference between investing vs speculating is the degree of risk, as well as the time period of the position. Based on your degree of skill in analyzing markets and using trading strategies, as well as your goals, you can decide which route suits you best.
High-risk trading (speculating) is often comparable to gambling. To minimize risk, a trader needs to develop a reliable strategy based on education and, once they begin, experience and analysis of their trades.
Do I have to choose between the two?
However, investing and speculation aren’t mutually exclusive. They can be complementary. For example, if I have shares in a company that has been publicly traded for a long time but is in a downtrend, I have the option of resorting to speculation to cover that position. To do this, we can resort to Contracts for Difference, or CFDs, a derivative product whose price is based on that of an underlying asset and which allows trading in bear markets.
In this case, we could sell a CFD on the share we own and thus offset the loss in value of our investment without having to sell the shares we own.
If you want to start trading CFDs on shares with virtual money, Admirals offers a free demo account with no obligation. And, if you feel ready for real trading, just click on the following banner and open a real account:
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- What is CFD trading? Contracts for Difference Explained
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.