One of the key drivers of participation in the stock market is the allure of fast money. Time and time again, you see investors in movies and online ads stepping out of cars with six-figure price tags, fishing on extravagant boats, and living in the lap of luxury.
The idea that you have the ability to get rich overnight by participating on Wall Street leads many to want to learn more about the stock market and how to tap into the tremendous profits that can be generated within it.
However, one reality that all beginner investors should know is that if there’s potential for tremendous reward, there’s also potential for tremendous risk. In fact, those chasing the fast money are generally speculating, not investing, and speculation comes with significant risks.
Here are the differences between speculating and investing, and examples of who should speculate and who should invest.
What Is Speculating?
Speculating in the stock market is nothing more than making a lightly educated guess as to what’s going to happen in the future. Speculation is based on theory rather than fact, and because nobody can tell the future, those who take part in speculation are often wrong.
For example, let’s say company ABC is a startup that’s created compelling technologies in the clean energy space and done well in terms of acquiring patents to protect its technologies. Unfortunately, ABC has fallen on hard times. Although the company has great technology, it has run out of money and can’t afford to market its products.
As a result, ABC announces that it’s exploring strategic alternatives, including the potential sale of the company. If the company sells, the transaction will likely take place at a premium, offering a strong short-term return on investment for those that dive in.
In these cases, speculators often purchase shares in the struggling company in hopes that an acquisition will happen. If it does, the speculator stands to earn a compelling short-term return. However, if the company doesn’t sell, bankruptcy is likely around the corner for ABC, which would ultimately lead to significant declines in stock prices and significant losses on the speculative investment.
Essentially, speculating is the process of buying a stock while placing little value on technical or fundamental analysis. Instead, speculators look for stocks where opportunities to make a quick buck based on the if-then idea exist. For example, if the company is acquired, then the speculator will turn a strong profit.
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What Is Investing?
Investing is a much more detailed and far safer process. Unlike speculators, investors look for opportunities based on intrinsic value derived from strong fundamental analysis skills.
Ultimately, an investor would never buy a stock that’s on the verge of bankruptcy, nor does an investor rely on a single action or event for a strong return on their investment. Instead, an investor buys common stock in companies that have strong balance sheets, produce compelling profits, pay dividends, have a strong history of growth, or a mix of these factors.
For example, say you discover XYZ stock and are interested in the opportunity it provides. Before purchasing the stock, an investor begins a process known as due diligence, or simply doing the research required to ensure that the investment is likely to produce a strong return with minimal risk at its current valuation.
In your research, you see plenty of cash on the company’s balance sheet with relatively little debt. You notice that over the past four consecutive quarters, revenue, earnings, and cash flow have experienced growth, and the company consistently pays dividends to its investors. Moreover, the company’s products are leading the way in its sector and the probability of continued success seems high.
So, you decide to buy the stock.
In the best-case scenario, the company continues to perform well and the stock rises. Although we’ve learned with Enron that anything can happen on Wall Street, the probability of significant losses like those often experienced in speculative trades is far lower when investing in a company of XYZs stature.
Examples of Speculating and Investing
One of the most popular examples of a highly speculative asset is cryptocurrency. Cryptocurrency was born as a challenge to central banks around the world. The idea is that by taking the central banks out of the equation, currency becomes more stable, secure, and trusted.
As a result, cryptocurrencies like Bitcoin have taken off among the investing community in recent years. However, a bet on Bitcoin or any other cryptocurrency is a highly speculative bet against currency as you know it today — and therefore a high-risk bet.
By contrast, one of the best examples of investing is real estate investing. Real estate investors purchase houses and other forms of real estate with the expectation that property values will gradually rise over the long term.
In the meantime, those who invest in real estate have the opportunity to invest further and renovate to expand gains, or rent out their properties to generate income. No matter how you look at it, real estate investing is one of the most popular and classic examples of traditional investing out there.
Risks of Investment vs. Speculation
In terms of managing risk, investing is the clear winner. When investors take the time to do their due diligence and only invest in companies that have a strong history of success, their investing portfolios are exposed to a relatively low amount of risk.
Conversely, when speculators buy stock based on a hope and a dream — whether they’re looking for an acquisition, a young startup’s success, or a wide range of other events — they accept a large amount of risk.
So, if you’re a risk-averse investor, you’ll likely do best with investment strategies focused on quality fundamental analysis, fair valuations, and a minimal level of risk.
However, if you like to live on the wild side and are willing to accept significant risks in exchange for the potential for tremendously high returns, speculation may be the way to go.
Nonetheless, there’s a difference between a high risk tolerance and making blind moves with your money. Research and analysis are important no matter how you plan to make your money in the stock market.
Rewards of Investment vs. Speculation
When it comes to the rewards on winning market moves, speculating takes the crown. Investing is the process of building wealth through slow and steady compounding gains over a long period of time. In fact, the average return of the S&P 500 is around 10% annually. That means a $10,000 investment will return about $1,000 per year on average.
To put it simply, intelligent investors don’t take part in get-rich-quick schemes. Instead, they make smart financial decisions over time, managing investment portfolios that provide consistent returns that compound over time.
Although speculation often leads to significant losses, it also has the potential to lead to significant gains. Using the example above, if ABC does get acquired, it will likely receive a strong premium. The average premium in a Wall Street acquisition is about 30.6% according to BCG.
Even if it were to take three months for the acquisition to close, the speculative trade would clock an annualized return rate of more than 120%, or a profit of $12,000 on an investment of $10,000. That’s significantly greater than the average of around 10% annualized return realized through traditional investment strategies, ETFs, and mutual funds.
Is High Volatility Best for Investors or Speculators?
Volatility is a measure of the fluctuations in values in the stock market. High-volatility assets are known for wide swings in value over a short period of time while low-volatility assets are best known for their relatively slow and steady movement.
For example, a clinical-stage biotechnology company with a promising treatment under development but financial struggles along the way will see tremendous growth around positive data releases but massive declines when money is raised through dilutive stock offerings to cover the cost of research.
On the other hand, a more established utilities company has a set book of customers that grows with the population and will experience low levels of volatility. As a result, the company generates a profit consistently.
These types of stocks tend to be more stable, with slow and steady movement toward the top when utilities are hot and slow and steady declines when utilities stocks correct.
For investors, the low-volatility utilities stock would be the way to go. It’s the kind of stock that you buy and hold for a while, banking on relatively consistent growth. For the speculative trader, the high-volatility biotech stock would be attractive. Buying in at low valuations after offerings and selling on highs after data releases could yield compelling short-term gains.
Analysis Styles Used by Investors and Speculators
In the stock market, there are two key types of analysis used by both investors and speculators. They are known as fundamental analysis and technical analysis. Here’s a brief overview:
- Fundamental Analysis. When analyzing a stock or other financial asset from a fundamental standpoint, the investor or trader looks into the financial health, management team, product, and market opportunity the company brings to the table. Fundamental analysis is based on looking for intrinsic value signals that suggest long-term growth is ahead.
- Technical Analysis. Technical analysis is based on the idea that history repeats itself, both in life and in the stock market. Therefore, by analyzing movement from the past and defining trends and pivot points, you have the ability to predict when a stock is likely to rise and it is likely to fall.
By nature, an investor will generally use fundamental analysis most. The idea is that by looking into the strength, stability, and innovation of the company, you’ll have a good idea of whether its value will grow in the long term. Although fundamental analysis is great for the long-term investor, it matters less for the short-term speculator.
On the other hand, investors will use technical analysis, but only when they’re already considering buying or selling a financial asset. In these cases, investors use technical analysis to find the best entrance and exit points.
However, traders and speculators live by technical analysis. If the technical data suggests an opportunity for dramatic growth, and there’s a rumor or reason to speculate that something big is going to happen ahead, the speculators tend to dive in.
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Time Horizon Differences Between Investing and Speculating
If you’re like most, you’ve heard the old adage “time is money” again and again. There is nowhere this statement is more true than in the stock market. In the blink of an eye, the values of stocks and other financial assets can dramatically rise or fall like a penny dropped from the Empire State Building.
It’s also important to think about time horizons when making an investment or speculating. Are you going to buy and hold an asset for years, months, weeks, or days? How do investing and speculating differ in terms of time horizons?
Naturally, investing is a long-term game. So, most investors buy stocks and hold them for years. In fact, famed investor Warren Buffett suggests that if you’re not willing to hold a stock for a decade, you shouldn’t own it for a day.
On the other hand, speculating tends to have a short time horizon. It’s a binary concept, suggesting that either something will happen that leads to tremendous gains quickly, or it doesn’t, and prices likely fall dramatically. Time horizons on speculative trades can range from one hour to one month, but are rarely held for any extended period of time.
Pros and Cons of Speculating and Investing
As is the case with any strategy to make money in the stock market, investing and speculating come with their own lists of pros and cons. Some of the most important include:
- Potential for Tremendous Gains. Although speculating is a risky business, it’s also a potentially lucrative business. High-volatility stocks with a reason for speculation have the potential to generate daily gains in multiples of what the average investment would return in a year.
- Excitement. Speculating and taking advantage of short-term growth stocks come with an increased level of risk. However, human beings are often excited by risk, so when speculating, there’s never a dull moment.
- Potential for Extreme Losses. Speculating is dangerous. Oftentimes, stocks see gains in multiples in hopes of a coming acquisition or another big story. However, when the catalyst doesn’t happen, all the speculators abandon ship. If you’re not one of the first jumping off, you’ll be left “holding the bag,” as they say — in other words, eating the losses.
- Low Probability of Success. Speculating is based on an educated guess that a catalyst is on the horizons, with smart speculators doing a little technical analysis to find the best entrance and exit points. However, trading on a hunch is always risky business and results in a much lower probability of success than traditional investing based on strong due diligence with a long-term time frame in mind.
- High Cost. Even if your broker doesn’t charge commissions or trade fees, there are always regulatory costs associated with every transaction you make in the stock market. The more money you move on a regulator basis, the higher your costs will be. Therefore, those who make long-term investments generally make fewer transactions and thus pay fewer fees.
- Reduced Risk. Due to the intense research that goes into the act of investing, and the scale of company most investors look for, risks are greatly reduced when investing as compared to speculating.
- Build Wealth Over Time. Investing is how some of the world’s most wealthy people built their wealth over time. A simple search online will yield countless rags-to-riches stories of people who were dedicated to investing their extra funds and eventually became millionaires as a result.
- Generate Income. Some investors, known as income investors, specifically look for stable companies that pay dividends. These dividends act as tax-advantaged income, increasing your pocket change with a lower tax burden than earned income.
- Slower Growth. Investing isn’t quite as exciting as the fast-paced world of speculating. If you’re looking for quick money in the stock market, investing isn’t the way to go. Then again, if quick money was so simple to come by, few would keep 9-to-5 jobs.
- Detailed Research Required. Investing is not a passive process. In fact, it’s actually pretty time-consuming. Several hours of research will go into each investment decision you make. So, you’ll need to be willing to perform this due diligence to increase your chances of success should you decide to invest.
Who Should Invest and Who Should Speculate?
Absolutely everyone should invest. Even if you take part in speculation, speculative trades should only represent a small portion of your portfolio. Hedge your more speculative bets by maintaining a portfolio centered around diversification with the majority of your assets being allocated to lower-risk investing activities.
So the real question is, who should speculate?
Speculation isn’t for everyone. If any of the following bullet points describe you, it’s best to stay away from the act of speculating:
- Beginner Investors. Because of the high risk of loss associated with speculation, it’s best that beginner investors steer clear of these types of moves in the stock market.
- Risk-Averse Investors. If you’re not comfortable with taking on a high level of risk in exchange for a high potential reward, speculation is not the way to go. It’s best to stay on the lower-risk, traditional investing side of the fence.
- Investors With Poor Technical Analysis Skills. Stocks at the center of speculative trades tend to be high-volatility stocks. As a result, if you’re going to speculate in the stock market, you’re going to need to have the technical analysis skills it takes to make sure that you’re buying in on lows and selling on highs.
Speculating is common in the stock market, but it’s also dangerous. Unfortunately, many beginner investors take part in speculative trades before realizing the risks.
The simple fact is that the vast majority of readers shouldn’t consider speculating. If you’re reading to learn the differences between speculating and investing, your level of experience likely doesn’t yet match veteran traders who have the best potential for success as speculators. Moreover, even most of those experts shy away from the practice.
All in all, the best way to go is to do your research and invest in stable companies that offer a strong history of stable growth. Although the potential for fast-paced growth is nothing compared to speculating, the potential for dramatic losses is also drastically reduced.