Investing vs speculating: Know the difference

Manvi Agarwal
·5-min read

According to the Merriam-Webster dictionary, a speculator is:

a person who thinks or guesses especially in an idle or casual way about something that is unknown or uncertain

a person who makes a relatively risky investment in something (such as stocks or real estate) in the hope of making a large short-term profit from market fluctuations

But how does this differentiate an investor from a speculator? After all, an investor is also speculating. He is also making a guess or an estimate of the value of a particular stock/company. But if you were to look closely, a keyword is missing. While an investor is also making a guess, his guess is an educated one.

An investor arrives at an estimated value after conducting his independent fundamental research. Unlike a speculator, he does not base his entire decision on hearsay, but on research instead.

Speculating is vastly different from investing

Speculating is a lot like betting or gambling. As a speculator, you are hoping to make a quick buck based entirely on luck. Without any understanding or background research, you are betting that something will work in your favour. Which, truth be told does work sometimes. But relying purely on luck can be risky as the rules of a gambling house apply here as well; in the end, the house always wins whereas the investor loses.

History also tells us that trying to make a quick buck over the short-term, by buying and selling frequently never works, especially when you are looking to create wealth over the long-term.

Investing, on the other hand, is different. According to the dictionary investing means:

to commit (money) in order to earn a financial return

Notice how they used the word 'commit'. It implies that you are buying something for the long haul. It is a lot like buying a house. You don't just buy one simply because someone suggested it or base your decision on rumours and tips. You conduct thorough research, study all aspects, understand all prospects and buy it for the long haul.

So, investing is all about taking on calculated risks. It involves understanding a line of business, its prospects and giving it time to grow.

Investing in stocks

‘’If you don’t study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards.’’

Pros and cons

Investors

Higher probability of normalised profit/returns

Lower probability of losing the entire capital

Lower probability of supernormal returns over the short-term

Investors have to be very patient.

Unlike speculators, investors make an educated guess. Their assumptions, on the rise or fall in the value of an investment, are based on fundamental research. This research can help reduce the risk that comes with investing. And while it cannot eliminate the probability of a loss, it certainly minimizes it.

So, unlike a speculator, there is a good chance that an investor will not lose his entire capital. Besides, he will also have a fair idea of the kind of return he is likely to generate from his investment.

But, while investing comes with a higher degree of certainty, it also takes a fair amount of time to generate results. It makes patience one of the most important virtues of an investor. It is also perhaps, the only downside to investing.

Speculators

Lower probability of profit

Higher probability of substantial loss

Higher probability of supernormal returns over the short-term

Speculators can make supernormal returns over a short period. But, much like gambling, there is no certainty or even clarity of an abnormal loss or profit. Besides, speculators face a high probability of losing their entire capital in a wrong bet. Mainly as speculation is making an assumption made on shaky grounds.

A few months ago, when the fate of Yes Bank was hanging in the balance, several speculators flocked over to make a quick buck. They were effectively betting on the future of the bank; if it would be merged or find a new investor etc.

Unfortunately, it did not pan out well, and the stock price tanked. But if the bank had managed to find a new owner at a good price, the speculators would have made supernormal returns in no time.

Speculators have a high appetite for risk and are often in a do or die situation. The downside to speculation is a high level of uncertainty and a real risk of substantial loss. So if you are looking to speculate, ensure that you have a large appetite for risk.

As risky as speculating is, interestingly, it can help investors.

Even a handful of risky speculative investments in an otherwise safe portfolio can boost overall returns.

Investments that are highly speculative can indeed hold a place in some investors’ portfolios, but it should purely be a function of their risk tolerance and goals. Depending on how much volatility you can comfortably withstand, it is prudent to adjust your portfolio accordingly when it comes to speculative investments.

In most cases, it is clear that you are either investing or speculating. But sometimes you can classify an investment as either. A classic example is the risky small-cap space. But not all small-caps are speculative as some do have predictable earnings and enjoy a competitive advantage. And so, if you invest in such companies at a discount to the fair price, you are effectively not speculating. Eventually, no matter what you choose, investing or speculating, ensure that it matches your risk appetite and your long-term goals.