There is a lot of excitement right now about investing and I think that’s a good thing, but how do we know if we are investing vs speculating?
In this article, we will:
- Define Investing vs Speculating
- Review Intrinsic Value & Asset Types
- Help You Avoid Speculating
So, let’s define investing vs speculating…
What Defines Investing?
Investing is defined as the act of allocating resources, usually money, with the expectation of generating an income or profit.
The focus is on the long-term returns of the investment.
What Defines Speculating?
Speculating is purchasing an asset with the hope that it will become more valuable in the near future. Speculating involves a shorter time horizon and can even be hopes of turning a profit within days.
This is how day traders attempt to make money. This is usually with complicated investments that they hold for short periods of time.
Investing vs Speculating Differences
So investing and speculating have similar definitions in the sense that they both have the same goal of making money. However, there are some key differences.
Speculation has a focus on the short-term
Investing focuses on the long-term
Short-term = Less Than 5 Years
Long-term = More Than 5 Years
The second key difference between investing and speculating is the words Expectation vs Hope.
When someone invests, they are diligently researching if the investment will be a good one with reasonable expectations of generating an income or profit.
When someone is speculating there is only hope for future income or profits.
Investing = Expecting Returns
Speculating= Hoping For Returns
What Is Intrinsic Value?
To make something an investment I would say it also has to meet another set of criteria. The investment has to have “intrinsic value” and be a productive asset.
When you purchase a rental property, that property has some intrinsic value, which is the plot of land it sits on or the materials used to build the home. Home prices can fluctuate for a lot of reasons (supply & demand, natural disasters, mortgage rates).
However, intrinsic value cannot be less than the cost to build the home.
Usually, the intrinsic value of a home is at the very least is the price to build & the price of the land.
Productive vs Non-Productive Assets
Investing also requires the asset to be a “productive” asset. Productive assets have income-generating potential. In contrast, non-productive assets at best can only store value.
Non-productive assets do not produce anything.
Examples Of Productive Assets
- Real Estate: Rental properties create rental income for the owner. This rental income doesn’t depend on the property appreciating in value. That’s why most real estate investors suggest you do not factor future appreciation to value investment property. They would rather you focus on the investment returns you can count on instead of hoping for an increase in price due to appreciation.
- Farms: When you own a farm you harvest the crops from the land and sell them for a profit or income every year.
- Stocks: When you own shares of a company you are entitled to some of the profits of the company in the form of dividends. Stock prices also rise but this is based on their earnings. (Sometimes stocks become speculative when prices rise due to reasons other than company earnings)
Productive assets are what I would consider real investments. With the right research and a focus on the long-term, they have a high probability of giving you an excellent return on investment (ROI).
Examples Of Non-Productive Assets
Speculation is when you buy something that doesn’t have intrinsic value and you only buy it with the expectation that someone will pay more for it in the future.
This might surprise you but… gold is an example of speculation.
- Gold: It doesn’t produce anything, therefore it is a non-productive asset. It sits there waiting for someone to value it at a higher price. Now to be fair, gold has at least proven over several hundred if not thousands of years to be a decent way to store value. It can keep up with inflation but your money doesn’t grow because gold is not producing anything for you.
Two Non-Productive Assets Combined!
- Bitcoin: This is even higher risk speculation compared to gold because Bitcoin really doesn’t have any intrinsic value. It doesn’t have a history of being able to store value, and it doesn’t produce anything. With Bitcoin, you’re really hoping someone will pay more for it in the future just because they believe they will sell it for higher later on. Bitcoin falls perfectly into the “greater fool” theory…
The Greater Fool Theory
The Greater Fool Theory is the idea of buying overvalued assets to later sell them for a proﬁt. Using this logic, there will always be someone willing to pay a higher price.
The greater fool theory describes people’s willingness to invest in something regardless of its real value.
This is a speculative approach and it’s based on the belief that you can make money by gambling on future prices. During market bubbles, you can always find a “greater fool”.
Bubbles only burst when there are no “greater fools” left. (Bubbles always burst)
Not surprisingly, the greater fool theory can be applied to many non-productive assets. Some like Beanie Babies, Pokemon cards, and Tulips.
However, it also happens with the stock market.
The Greater Fool Theory becomes relevant in stocks when the price of a stock is being driven by the expectation that buyers can always be found, not by the intrinsic value such as cash ﬂows or profits of the company.
Therefore, any price can be rationalized since another buyer supposedly exists who is willing to pay an even higher price.
“Greater fools” are generally impatient investors who are attracted to popular or “hot” trends in the market. They are not interested in steady, consistent returns, or value.
How To Avoid Speculating?
Invest For The Long-Term
The long term is over 5 years and ideally between 10 to 30 years. Some long-term investors never plan to sell. If you plan to hold forever you can eliminate the speculative assets because those usually require you to sell to regain your investments.
As I mentioned, real estate and stocks spit out rental income and dividends so you don’t need to sell these investments to make a return.
Don’t Fall For The Latest Trends
Don’t watch the news or stock prices. This is something I struggle with but hope to one day be able to stop watching the stock prices fluctuate daily.
When you get your retirement plan statement every month, don’t open it. Don’t peek. When you retire, open the statement and believe me if you’ve been putting money in there for 40 or 50 years, you’ll need a cardiologist standing by you when you open it!
– John Bogle
Avoid Tinker With Your Investments
Speculators buy and sell based on changes in market sentiment or for political reasons. They try to time the market.
A piece of advice that can save you from making costly mistakes and adding years to your investing goals is to stay the course!
Again, John Bogle said it best, when the market is having one of its tantrums instead of “Don’t just stand there do something” it should be;
“Don’t do something just stand there”
– John Bogle
Remember that there are no get-rich-quick routes to financial independence (FI). Financial independence and building a good investment portfolio take time.
Be happy with the small wins and learn to accept the challenges while celebrating your progress. Set up milestones like your first $1,000 in investments or first $10,000.
If you make good investments you will see how your money begins to grow like a snowball.
Good Investments Involve:
- Long Time Horizon
- Thorough Research
- Intrinsic Value
- Productive Assets
- Staying The Course
The growth starts slow and as it compounds over time the amount grows quicker and easier. The first 10,000 is the absolute hardest and it gets much easier after that!
So I hope this has been useful to you and helps you become a better investor on your path to financial independence.
For more great information about investing I recommend listening to the episode when I interviewed JL Collins about investing.
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This information is my opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.