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Speculating vs investing: here’s how they differ

Speculating is a bit like gambling except speculators try to make an educated decision on the direction of their trades.

A friend recently remarked that he was becoming increasingly despondent with the sluggish performance of his unit trust portfolio over the past few years. He was in a number of the well-known balanced funds, which have not had a particularly good run over the recent past. As a result, a couple of months ago he decided to withdraw the funds and to rather invest in a number of ‘schemes’ that are now paying him a favourable income every month.

He is not entirely sure what the underlying investments are but mentioned property and crypto. He is extremely happy with the results so far as he is receiving between 10% return per month. This set off some alarm bells for me, given that the current money market return is closer to 4% … per annum!

Too good to be true?

We didn’t go into the details of the schemes but given that money market rates are currently around 4% per annum – which is a good benchmark for a risk-free rate – and at the other end of the spectrum expected equity markets returns are around 12% per annum, a 10% PER MONTH return sounded way too good to be true!

These schemes could be legitimate business schemes but I had my reservations. What can they be investing in that is giving rise to these way above-average returns? The questions are what are the underlying investments? Can it continue giving such great returns over the long term when market and economic conditions change? What is the risk of a permanent loss of capital?

This brought up an interesting discussion on the difference between speculating vs investing.

Speculating

Investopedia defines speculating as the act of putting money into financial endeavours with a high probability of failure.

Speculators seek abnormally high returns from bets that can go one way or the other. There is therefore an above-average likelihood of losing all your capital as a speculator. Speculators are normally short term focused and will change their position frequently.

It’s a bit like gambling except speculators try to make an educated decision on the direction of their trades and whilst gambling can also be about the odds of something happening, there is more reliance on luck. A lot of speculators are drawn to a particular scheme because of the lure of recent great returns and not wanting to miss out. Many don’t understand the risks – the very real risk of losing all their capital.

Sometimes speculators are financially desperate to turn a deal and make some quick money. This can end up being disastrous for speculators. Mirror Trading International (MTI), which is about to be liquidated, is a case in point. The Financial Sector Conduct Authority advised the public to steer clear of MTI in August 2020 on the basis that it was operating without a proper licence and was making extravagant claims of returns of up to 10% a month, using a computerised trading system.

Investing

Investing on the other hand is about buying and holding onto an asset for a long term (longer than five years) return. The returns can come in the form of interest, dividends, or capital appreciation. Investors are looking for a satisfactory return on their capital by taking on a below-average amount of risk. The risk of an investor having a permanent loss of capital is lower than that of a speculator.

Investors generally use analysis and research to make an informed investment decision.

Investors look for opportunities to make a return on their capital but will always take the risks into consideration. Investing does not necessarily mean that the returns are dull but rather that the risks are well considered before investing for an above-average return. With a longer-term focus, investors can take on the volatility risk but will look to mitigate the risk of a permanent loss of capital.

Back to my speculating friend. It is important for him to understand the difference between investing and speculating and the very real risk he faces of a permanent loss of capital. He needs to feel comfortable with the risks.

If he has done the financial planning and can afford to lose the capital and still maintain his lifestyle whilst staying on track with his longer-term financial goals, then he can continue speculating.

If like most people, a permanent loss of capital would be financially devastating, I would recommend that he consider working through a financial planning exercise, calculating if he has surplus assets and earmarks a specific amount that he can afford to speculate with. The balance of his investments should be well-diversified and targeting a long term risk-adjusted return.

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Hmm this is a very shallow definition of speculation. Speculation can be taking short-term momentum based positions in stocks based on Technical Analysis, many deem small cap investing as speculation due to liquidity and volatility, one can speculate using derivatives like options and futures. Sometimes there’s an overlap between investing and speculating. Ponzi schemes and the likes of MTI are more gambling and should not be confused with speculating as speculating also requires a lot of research and analysis, main difference being it’s more aggresisve with a shorter timeframe than investing.

I agree with most of what you said.

But, I do not agree with the definition of speculation. For one, speculation and gambling are not the same, even if you think of Binary options.

A good speculator understands the need for deep technical and fundamental analysis to know when to take risks or exit markets. Speculation is not guess work like sports betting.

End of comments.

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