Speculating vs investing: What’s the difference
One of the fundamental issues in Finance is the relationship between risk and return. Investors are willing to commit their resources for a period of time in the expectation of receiving future cash flows that will compensate them for the time they have committed their money, the expected rate of inflation and the risk they have undertaken.
Individuals invest for a variety of reasons: for creating a retirement fund; for funding their children’s education; for putting a down payment on a new house. Organizations invest for numerous reasons: for creating payouts for their retired employees (pension funds); for providing scholarships (endowment funds); for providing adequate funds to policy holders when policies need to be cashed out or benefits need to be paid (insurance companies).
In any case, investing covers three basic needs:
Income: investments are made in the hope of providing future income. Investors are trading their money today for expected income streams that will outweigh the current outlay.
Capital preservation: investments are made to preserve capital. Investors put their money on conservative investments because they are not willing to undertake any risk. On the contrary, they are looking for the assurance that the funds will be available, with no risk of loss. In this context, capital preservation refers to the preservation of the real value of the investment as the nominal value will increase according to inflation.
Capital appreciation: investments are made so that capital grows in value and meet future needs. The goal for those investors who are wiling to undertake a certain risk is to grow their funds at a faster rate than inflation so that they enjoy a higher return on their investment after inflation and taxes have taken effect. Normally, investments made for capital appreciation involve risk exposure and risk can affect returns both positively and negatively.
Speculation refers to the undertaking of extra risk to achieve above-average returns in a relatively short-term horizon. Unlike investing, that is a well-informed decision after having taken into consideration a series of economic, market and company factors, speculating is, in effect, a betting on future movements of the market. Speculators take specific positions in the market, either by betting that the price of an asset will rise or by betting that the price of an asset will decline and use derivatives to get extra leverage.
For example, a US speculator believes that the British Pound will strengthen relative to the US dollar over the next 2 months and takes a position of 100,000GBP. The speculator buys 100,000GBP in the spot market hoping that GBP can be sold later at a higher price. We assume a spot price at 1.6580 and a futures price at 1.6530. If over the next 2 months the exchange rate rises to 1.7000 USD/GBP, the futures contract enables the speculator to realize a profit gain of (1.7000 – 1.6530) x 100,000 = $4,700. The spot market alternative gives a profit of (1.7000 – 1.6580) x 100,000 = $4,200. If over the next 2 months the exchange rate declines to 1.600 USD/GBP, the futures contract gives a loss of (1.6530 – 1.6000) x 100,000 = $5,300. The spot market alternative gives a loss of (1.6580 – 1.600) x 100,000 = $5,800. The difference between the two alternatives is that if the speculator goes with the spot price, he would have to make an initial investment of 100,000GBP x 1.6580 = $165.800, while if he uses futures contract he would deposit the margin account, that is an amount around $20,000. This how using derivatives allows speculators to gain leverage.
For Adam Smith, speculators are always ready to pursue short-term opportunities for profit; for John Maynard Keynes, their activities are aimed at forecasting the psychology of the market. On the contrary, investments forecast the prospective yields of the invested assets based on fundamental or technical factors that support investors’ expectations.
The problem between investing and speculating is that many investors do speculate although they are sure they don’t. For instance, investors who do proper analysis of the market know that they can hold a stock even if the stock price falls. If they are really savvy investors, they will increase their position in the particular stock to take advantage of its future uptrend. However, the opposite is true for speculators, who will sell the stock betting that the stock price will decline further. In general, speculation may mean different things to different people, but in its essence it has one original meaning, which is theorizing without a factual basis.
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