Speculation vs. investment - a complete guide for beginners
Many prospective traders remain unclear about the differences between speculation and investment. Newcomers to the market often fall into the trap of thinking that both are the same thing. In fact, this isn’t the case.
Nevertheless, though, a surprising number of traders who begin their journey as an investor end up being a speculator without realising it. Understanding your objective when trading couldn’t be more important, and since investors and speculators take very different paths it’s essential to be aware of what speculating and investing involve.
What does “investing” mean?
The dictionary definition of the word “investment” revolves around spending a set sum of money on a financial instrument, business, or project in order to gain profits. Essentially, investment is about putting your money into something you believe has value – usually funds or shares.
When you invest in the financial markets you need to make two vital decisions. Firstly, you need to decide on how much capital you’ll dedicate to your investment, and secondly, you’ll need to determine what you’re going to use the capital for i.e. what you’re going to invest in. When it comes to making these decisions, you need to carry out some key analysis. First, you need to thoroughly examine your finances then, afterwards, you need to consider the potential objectives you wish to achieve from the investment that you’re planning to make.
Although there are no hard and fast rules for investing, it makes sense to follow some sensible protocols in order to avoid costly errors. These include:
- Gaining a clear understanding of what you plan to invest in by thoroughly carrying out a complete analysis of all factors including the target of the investment’s sector, its competitors, the company’s own solvency, it profit margins, and also its expectations for the future.
- Taking into account the safety margin. The relationship that exists between the price of shares and their intrinsic value is known as the “safety margin”. The lower an asset’s price, the higher the safety margin, therefore this must be taken into consideration when choosing a wise investment.
- Taking a long-term approach. Returns can only come once the market has realised the asset’s true value. Therefore, investments should always be planned to be long-term commitments.
What is speculation?
Although there is a fairly fine line between investment and speculation, there are some key differences.
When people refer to speculation they mean the sale or purchase of financial assets which are likely to experience a fall or rise in their price in the near future. When compared with investment, speculation is far riskier since it aims to benefit from short-term fluctuations in price.
Both fundamental and technical analysis is used in speculation; however, since trading is only done on a short-term basis, technical indicators typically are decisive.
It's possible in practice to speculate on virtually any financial instrument’s price, not only traditional ones like shares, which is the case for investment.
Although it is contrary to popular belief, speculators’ decisions are not down to chance. Rather, they are the result of comprehensive technical analysis as well as in-depth training. Keen speculators will put considerable effort into learning how to carry out a thorough analysis of every aspect of the market as well as the instrument that they are investing in so that they can be as successful as possible in achieving their goal of making a profit.
Periods of high speculation
There have been some distinct periods in history when speculation was at an all-time high.
One of the most famous speculation bubbles in the history of the financial markets has to be the notorious Dot-com Bubble which occurred during the 1990s. Due to its size and scale, very few other bubbles can match this era when the internet’s growing popularity triggered an enormous speculation wave in the “new economy” technology businesses.
The result was the countless dot-com companies were given valuations worth billions of dollars from the moment they went public and the NASDAQ Composite Index soared to its peak of more than 5000 in the year 2000 from just 750 in 1990. By late 2002, however, the index plunged by 78%, crashing dramatically and causing a recession in the USA.
Another period of high speculation came in 2008 when America was in the height of a boom in its economy. At the time, unemployment was at its lowest point in a decade and investor sentiment was high. Unfortunately, numerous factors came together to cause a significant crash in the market.
With a liability and asset mismatch, the use of excessive leverage, excessive risk-taking from financial institutions and equity prices that were out of alignment with valuations, it was the recipe for a perfect storm that led to a major recession from which recovery was slow.
What are the differences between speculation and investing?
There are four areas in which speculating and investing have significant differences:
Typically investors keep their assets in their portfolio for many years. Meanwhile, speculators typically change assets on a short-term basis, usually within days, hours, or even minutes.
Investors thoroughly analyse all fundamental factors from company ratios, competitors, and conditions in the industry to technical factors across the asset’s entire history. Speculators, meanwhile, primarily only carry out technical analysis paired with market and fundamental sentiment.
An investor’s primary objective is to gain small and recurring returns over a long-term period for example through dividend payments. Speculators, meanwhile, seek to gain small profits over a short-term period.
Investors take only a moderate risk, although this, in turn, lowers the rate of return. Meanwhile, speculators take a higher risk but this gives them the chance of making higher potential gains.
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Are there any similarities between investment and speculation?
While there are some major differences between investing and speculating as outlined above, there are also some similarities between the two forms of trading, especially when it comes to the errors that are commonly made.
Often, traders go from being an investor to being a speculator without actually realising it. As an example, an investor may purchase shares in a company, having completed a comprehensive analysis, however after only a short while, the price falls, so the investor sells at a lower price than they initially paid. They then purchase a different stock which is currently on an uptrend. This move indicates a change from investment to speculation.
Another common error that plagues both investors and speculators is a lack of understanding and knowledge. Too many people start investing or speculating in the belief that market movements occur solely because of chance. The result is frustration and significant losses.
Which is best – investment, or speculation?
As you might imagine, there are both advantages and disadvantages to both speculation and investment.
When it comes to advantages, investing can be a less risky choice than speculation, and often a better option for anyone who is a newcomer to trading the financial markets. Speculation, on the other hand, offers the advantage of lower commissions, easier market access, a need for less capital because of leverage, and also a wider variety of available financial assets for speculators to select from.
When it comes to disadvantages, investing requires more upfront capital to get started, and the commissions that need to be paid are higher. There are also fewer instruments to choose from overall. The downsides of speculation, meanwhile, include a higher risk of loss, an increased level of stress, and a need for more training and dedication to achieve the desired goal of reaping profits.
How do I choose between speculating and investing?
When you’re trying to decide what kind of trader you wish to be, it’s important to note that you don’t have to actually choose between speculation and investment. In fact, both forms of trading can complement each other well.
As an example, if a trader has shares in a company which has long been public but is now on a downward trend, they can speculate in order to cover the position. This can be achieved by using CFDs (Contracts for Difference) – derivative products with a price based on their underlying assets that allow trading in a bear market.
The trader could sell a Contracts for Difference on the share that they own to offset the investment value that has been lost without needing to sell any of the shares that they own.
With this in mind, it’s clear that traders can opt for both speculation and investment to suit their needs at any given time. However, for anyone who wishes to specialise in one or the other, investing is often the best choice for trading novices who are looking for a less risky option with a lower commitment in terms of both training and dedication.
Not investment advice. Past performance does not guarantee or predict future performance.
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