6 second take: The differences between investing and speculating aren't always clear. Here's what you need to know.
Can you really invest in cryptocurrencies? Or is that speculating? There is a difference.
The distinction is more than semantics. The difficulty for many would-be investors is assigning attributes of investing to activities of speculating — and then being surprised by attaining an unfavorable result they may not have considered. Understanding the difference between investing and speculating is key to avoiding this trap.
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Investing
Investing is a process of attempting to produce long-term returns in excess of inflation through allocation into investment vehicles. Investing is predictable and replicable.
The basis for investing is typically historical. Investors select investments based on their historical track records, although they may take current factors into account in either discounting or overweighting certain categories.
Investors consider risk, measurable in terms of volatility or expected range of returns, across a period of time. Investors use a variety of strategies to mitigate their risk, such as diversification across and within asset classes.
The time horizon is important in investing.
Generally speaking, risk is a variable with a time relationship; short-term price fluctuations decrease in importance across longer time frames.
Short-term risk is generally a lesser issue in investing as the time horizon is such that short-term fluctuations in price are not important. For example, if investing for retirement 10 years away, the value of the accounts one month from now is relatively unimportant as compared to the value 9.5 years from now.
Saving
Saving bears mentioning as a special subset of investing strategies. Investors invest for long-term goals and save for near-term needs. The difference between the two is in risk: Investing involves risk due the volatile nature of most investments. Savings prioritizes safety of principal over return; risk is reduced in favor of stability.
We save for things like a vacation next summer or for building our emergency funds. We forgo the typical goal of investing — producing a return in excess of the rate of inflation — in exchange for reducing the potential loss that might be incurred in an investment subject to market fluctuations.
This exchange, giving up return in exchange for safety, generally produces a negative real rate of return for savings. Real rate of return is the nominal rate of return minus the rate of inflation, in other words, the change in purchasing power of your funds.
Investing, in the long-term, seeks to grow purchasing power by exceeding the rate of inflation; savings generally will not grow your funds, but instead keep them secure for possible near-term use.
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Speculating
Speculating is attempting to create a profit or gain by taking advantage of knowledge or current conditions in a market or markets. Speculating tend to be short-term in nature. Current conditions affecting a market can create a near-term opportunity, or at least appear to do so.
Speculating is based on a current situation or the potential of a situation to develop in the near-term. This is very different from investing, which is based on historical data.
Where an investor seeks potential long-term advantage based on historical data, speculators seek short-term advantage based on near-term situations or their anticipation of changes in the near term.
The outcome of a speculative endeavor is not clear nor predictable in a fashion similar to investing. The speculator often thinks the outcome is predictable due to their superior knowledge or interpretation of events, so they are willing to assume what appears to be a high level of risk.
The Risk/Reward Relationship
There is a distinct difference in the risk/reward relationship between investing and speculating.
Investors assume a degree of risk that diminishes across time; they accept short-term price fluctuations as part of achieving positive real rates of return across time.
Speculators assume a high degree of risk that price changes will occur in the direction and magnitude that they have anticipated and will do so in the near term.
The value to the investor is in long-term results. Investing needs time to produce results; the risks of investing are managed and reduced across longer time periods.
The value to the spectator is short-term results. Time does not serve the speculator, as speculating is based on changes in a current situation. There is at best limited historical basis for speculation; there is no reasonable probabilistic modeling of potential near-term price changes.
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Speculating vs. Gambling
Gambling is a subset of speculating, like saving is a subset of investing. In gambling, probabilistic returns are clear and known. You know the chance of the wheel landing on red or black. You know the chance of the next card drawn being a face card. You know the chance of selecting the winning numbers in a lottery.
The outcome of gambling is predictable in a large set of trials.
The gambler is trying to take advantage of what is a clear losing strategy in the long term. You know that when you purchase a lottery ticket your expected return is zero, but there is an extremely small chance that it may be a very big win.
Most speculating does not have the clear probabilistic basis of gambling. The effects of weather on crops, or potential legislation on an industry, are not based on the law of large numbers, they are based on yet to be determined market effects. The exact risk in gambling is determinable in advance, which is not they normal case in speculation.
Which Are You Doing?
The answer is not always clear. Here is one way to think about it.
Though investing and speculating are clearly different, they are much like bookends on a continuum of options. There is a range of possibilities in between what is clearly investing or clearly speculating.
When looking at accumulating for long-term goals, investors should not find it difficult to determine which they are doing — or else that is a sign of potential trouble. Prudent asset management will clearly fall into the realm of investing.
The difficulty often arises from attempting to speculate with the same investments you use for investing. You can, after all, try to time the market with stocks or funds. That is clearly speculative, although those same investments could be used as part of a long-term strategy.
You might find that you have wandered from the investing end of the spectrum into a middle area where you are trying to do both. Historically you are likely to achieve lower returns trying to time the markets.
The clarity comes from intent. If you are using historical information to structure a portfolio to achieve returns in excess of inflation on a long-term basis, then you are investing; if you are using current situations or market conditions to attempt to create a gain in the near term, then you are speculating.
Now you can consider those funds you were thinking of putting into a cryptocurrency and know what tactic you are seeking to employ.
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