The Difference Between Investing and Speculation

TL;DR => If your strategy is to get paid for holding an asset, you are investing. If your strategy is to get paid for selling an asset, you are speculating.

About three years ago, I find myself having turned a corner when it comes to investing for wealth creation and retirement. This corner is the threshold between speculating like a greedy young gambler, and investing like a competent man of sound mind. The questions I researched and studied became less about what is the next hot investment promising outsized returns, and more about the simple charge as to how a reasonable man invests his capital.

Perhaps due to this retreat to reason, I am now asked on occasion to provide basic financial orientation to people asking questions such as “how do I invest my retirement money?”, or “my kids want to get into stocks, what do I tell them?”.

While I am no doubt flattered by people recognizing a subtle financial competence and confidence, I often don’t know where to start with someone relatively new to investing. In my own journey of generally self-taught financial education, my interests were frequently piqued in the most speculative and foolish of pursuits - cryptocurrencies, high risk options, algorithmic trading, etc. However, as I tried (and failed) to learn and profit from such hazardous fields that attract the wide-eyed, fad driven fools like my younger self, I started to notice common references to concepts, thinkers, books, and ultimately truths that seemed to suggest a north star of financial truth.

When I attempted to learn how to time the market using options, I began to see deeper wisdom emerge that has withstood the test of time in Benjamin Graham and value investing. As I worked to figure out how to algorithmically trade a hedged portfolio, I stumbled upon Henry Markowitz and John Bogle who espouse diversification amongst asset classes and long term investment horizons. As I sought absurd overnight returns in cryptocurrencies, I learned the distinctly human rhythms of asset bubbles in the past and their telltale cyclical footprints in the speculative delusions of grandeur - from tulips and railroads, from tech stocks to cryptocurrencies.

The more I studied personal finance and investing, the more I found myself being repeatedly oriented towards some consistent and congruent truths. While my speculations were no doubt costly, they were not costly enough to deter me from attempting to answer the fundamental question - how does a man of reason invest his capital? As I endlessly seek the answer to this great question, I find myself having been thoroughly convinced by the evidence of some timeless truths. These writings are my attempt now to codify some of this knowledge of fundamental truths in order to have my thoughts organized for my own edification, as well as a starting point for others who come to me seeking guidance.

What is the difference between investing and speculation?

Investing is very different from speculation, yet the two terms are often used interchangeably. Investing is a label we wishfully assign to many cash outlays that are not true investments; rather, they are consumptive purchases.

Examples of consumptive purchases that are often characterized as investments are vacations, electronics, clothes, jewelry, and nearly all automobile purchases. These are not actually investments in the financial sense of the word, they are goods and services purchased with the intention of consumption, not the intention of deriving future profit. Investing in oneself, while albeit at times a worthy pursuit, is not a financial investment in the sense that it is not a purchase of an asset that will generate future income.

In a similar sense, we often mislabel assets we purchase as investments, when they are in fact speculations.

What is an investment?

An investment is an asset that creates future cash flow. An investment offers the potential for future cash flow in the form of profits to be paid to the asset owner. The future cash flows are derived from an operating characteristic of the investment. For example, when you own a simple restaurant, the restaurant operates and generating sales, and paying expenses to facilitate said sales. When the income is above the expenses, there is a profit, which can be paid to the owner of the restaurant. Restaurant ownership is an investment that creates the possibility of future cash flows for the asset owner.

Note that the owner of the restaurant does not have to sell any of the ownership of the asset to realize this cash flow potential. The restaurant owner is not tasked with increasing the value of the restaurant and selling it to another owner to create cash flow. Simply by owning the asset (and experiencing profitable operating conditions), the owner receives an income from their investment.

The key to understanding what an investment asset is in contrast to a speculative asset is that the potential exists for the asset owner to derive future cash flow simply through their ownership. Examples of investments that fit this definition include bonds, money market instruments, certificates of deposit, real estate, and most (but not all) stock market equities.

What is speculation?

We learn a hard lesson when we purchase a speculative asset and mislabel it an investment. A speculative asset is a financial purchase made with the intention of selling the asset at a higher price without materially changing the valuation characteristics of the asset. For example, we can purchase assets such as gold. By purchasing this precious metal, we are hoping that the value increases due to favorable market conditions. Perhaps there is an inflation shock or geopolitical conflict that causes the demand for gold to rise, and we thereby see the price increase. Good for us - we can now sell our assets for a higher price. At no point during our gold ownership do we get paid simply for owning the metal, we must actually sell it to realize an income in the form of a capital gain. This is speculation - we’ve made a purchase with the belief that the asset will rise in value and we will be able to sell it for more than we paid.

What is wrong with speculation?

Speculative investments are not inherently bad, but they must be purchased with the understanding that no cash flow will be realized from the asset. We will only receive a capital gain or loss. Some examples of reasonable speculative asset purchases include precious metals, currencies, high quality options, commodities, as well as many growth stocks with very high valuations.

Where the lessons regarding speculation truly become costly to learn is when we engage in “greater fool” style speculation. This is when we make a purchase simply with the belief that a "greater fool than us" will come along and be willing to purchase our assets at a greater price than we paid. We simply hope that we are not the last ones to the party, that others will come behind us to validate our financial purchase. This is a speculation - and responsible for the most awesome and catastrophic asset bubbles in the history of human capital markets.

Do "greater fool" style investments have a place in a reasonable man's portfolio?

Greater fool investments should be avoided by nearly every investor. While some speculative assets have value in a sophisticated portfolio as a way to achieve diversification or hedge specific risks, greater fool investments are nearly always a reckless gamble. Some examples of greater fool style investments include some of history’s most infamous bubbles including collectibles (Beanie Babies, sports trading cards, many types of art), high flying fad stocks throughout history such as canals, railroads, emerging markets, and tech, and the more modern bubbles that history has yet to pass a verdict on such as non-fungible tokens and cryptocurrencies. This is not to say that it is impossible to make money on greater fool style investments. Rather, I posit that the risk is not worth the reward. In almost every case, one simply does not get paid enough for the risk they are undertaking to warrant engaging in highly speculative asset purchases.

The core of any reasonable adult’s portfolio is investments, not speculations, and certainly not greater fool style gambles.