Investing vs. Speculating

Many people mistake the difference between investing and speculating. The key to distinguishing the difference is "risk".

Speculating is investing in something that has a greater possibility of both gain or loss. For example, when an individual stock goes through tough times and the price is very low, individuals look at this as a great opportunity to buy low and sell when the price returns to its former high valuation. This is called "bottom fishing" by Wall Street. The problem with this is two fold. One, there may be a good reason for an under performing stock to be priced low and it may not come back any time soon if ever! Two, if it does come back it could take many years causing the speculator to loss patience or not get the best return for their money. Through the years I have observed that those who speculate more often than not loss money.

The problem with speculating is that the enticement of the great possibilities of financial gain clouds the very real possibilities of losses. Any investment that has a high probability of losing all your money is speculation. If you want to speculate for fun or for the possibility of riches just understand that you could loss everything. If you can't accept losing everything don't do it.

Another example of speculation that I often see people salivate over is the promise of a new technology. You know that small company that is riding on one product that will revolutionize the way we do something-or-other. It's a great idea and the speculator can't see any downside to the investment. In reality there are many downsides, two in particular. First of all it is likely that many others have the pie-in-the-sky visions of this new product and the price is based on that optimistic outlook. Interpretation, the stock is overpriced. Since this company is basing it's future on this one product if anything goes wrong that's the end of it's life and your investment.

Speculating is a losing game, especially if done repeatedly. The reason is that you need to be right every time. Most speculators get burned the first time they make speculative "investments" which is to their benefit. Because it diminishes the possibility of them doing it a second time. I only say "diminishes" because many are unitised to speculate over and over, again only considering the benefits and not the risks. Take this scenario. You see a great opportunity to buy XYZ Corporation that is trading at it's lows and you buy $1,000 worth of the stock. A month later it shoots through the roof and it is now worth $10,000. You are a shrewed speculator so you sell it at the high and buy the next undervalued company with your $10,000. This next investment goes bust and you lose the $10,000. Not only did you lose this first investment but you lost them both since you no longer have the money you invested in the first place.

As Warren Buffett once said, "The first rule of investing is to not lose money." Many people don't want to take the slow route of growing rich slowly but by trying to get rich fast they more often than not are postponing their financial success through speculation.

Investing on the other hand is purchasing a well researched and/or diverse sampling of assets for the intention of long term growth. The key term here is "diverse" since diversification provides a greater probability for the investor to not loss all their money. With diversification if one component of the investment under performs it will not hurt the entire investment.

Behavioral Investing

One of my favorite subjects in financial planning is behavioral investing. This is easily the area that causes most investors to under perform or more likely inflict harm on their financial health. And this is not just restricted to the amateur investor but also the professional. In behavioral investing there are 2 extremes that I find most interesting, the under investor and the over investor. Both can be equally damaging.

The under investor is the one who closely watches the market year after year but never actually participates in the market for reasons of fear. If the market is going down this month than they are glad they are not in the market. If the market is hitting one new high after the other then it is not the best time to go in. That's one type of under investor. The other type is the one that doesn't even acknowledge the market because they have heard that people loss money in the market.

The over investor is the one that changes their "plan" based on short-term market trends and media talking heads. This investor will chase last years winner and incur excessive trading costs, and taxable events while underperforming the market.