We’ll discuss five key factors that distinguish investment from speculation, and discuss about one common mistake to avoid.
Sometimes, it’s easy to tell the difference between investing and speculating. Consider two people who prefer different approaches: one prefers a “buy and hold” approach (when financial instruments are bought and held for a long time without selling), while the other prefers scalping (when positions are opened and closed in seconds).
In other cases, the difference is more subtle. Is a person who holds a position for eight months and then sells it investing or speculating? Let’s look at key factors that separate investment from speculation.
Time Horizon
Time horizon is probably the most visible factor that distinguishes investing from speculation.
Investing is always associated with longer timeframes and involves putting money to work for years and even decades. An investment is a bet on the fundamental appreciation of the asset’s value, something that cannot happen overnight. In addition, investments provide investors with a stream of income, such as stock dividends or bond coupon payments.
In turn, speculators bet on the appreciation (or depreciation) of the asset’s price which can happen within a short timeframe. Speculators prefer quick profits as they are always ready to put their money to work on other ideas. Typically, speculators do not pay attention to the potential income which could be generated by the instrument.
Leverage
In most cases, investors do not use leverage. Since investors are willing to endure the ups and downs of the market over several years, using leverage does not make sense as it makes the position vulnerable to downside moves, and incurs a cost.
Meanwhile, speculators use leverage as it provides them with an opportunity to boost their potential profits. Speculators incur a cost when they use leverage, but the costs are usually insignificant since positions are often closed within days or weeks or, in the case of day trading, within just one trading session.
Potential Returns
Investors and speculators would both argue that their preferred method of making money is the most effective.
In general, speculation offers traders the opportunity to gain significant profits in the near term. In the past, traders’ performance often suffered because of significant commissions which accompanied active trading. Currently, commissions are minimal (sometimes, trading is commission-free), so market conditions have significantly improved for active traders.
Investing does not promise quick profits, but the results of an investor may look great in the long run if the investor’s performance is consistent and income is reinvested.
Put simply, speculation is a tool to “make money now”, while investing is used to “make money in the future”. It should be noted that both methods require sufficient knowledge and discipline.
Risk Levels
Speculation usually carries a higher risk level. There are several reasons for this. First, speculative trades typically involve leverage which increases risk. Second, speculation is focused on shorter timeframes where market behavior is more dependent on random factors.
For example, a sudden market-wide sell-off caused by news that is unrelated to the instrument may cause a temporary panic and push a trader out of a speculative position. Meanwhile, an investor will keep this position and enjoy future upside when the instrument gets back to fundamentally justified levels.
Fortunately, risks can be managed, and the level of risk ultimately depends on the skill of the trader or investor rather than on outside forces.
How Decisions Are Made
Investors typically make their decisions based on fundamental analysis. Some investors use technical analysis to find better entry points, but technical analysis does not serve as the basis for an investor’s decision. In the long run, fundamental factors are crucial, while technical factors are more important in the short run. As investors enter long-term positions, they must make their decisions based on fundamentals.
Not surprisingly, technical analysis is the main tool for speculators who deal with shorter timeframes. Although some traders consider fundamental factors, many speculative traders base their decisions solely on price action and general market conditions.
The Key Mistake To Avoid
After we have discussed the five most important factors that distinguish investing from speculation, we should discuss the biggest mistake made by both investors and speculators so that we can avoid it.
Here’s a simple rule: use only one method for both entry and exit. Sounds simple? It does, but many people break this rule, and their performance suffers.
Let’s look at a common example. The trader enters a long position based on technical factors, but the trade does not go as expected. Rather than closing the position, taking a small loss and moving on, the trader tells himself that he is now “an investor” and holds this position for days or even weeks. The luck may be on his side, but he may also become a “bag holder” – a poor investor watching his position decline in a long-term downside trend.
This mistake also affects investors. Some investors are tempted to take quick profits when an instrument’s price rises, essentially becoming speculators. The price of an instrument continues to rise over time if the original fundamental thesis was correct, and the unfortunate investor misses most of the price appreciation and income generated by the instrument.
Fortunately, this mistake is very easy to avoid. If you have entered a position based on the fundamental analysis, you should exit it when fundamentals change. In this case, technical analysis could be used as an auxiliary tool, but it should not guide your decisions. Do not let market action distract you and focus on fundamentals.
Likewise, if you have entered a position based on technical factors, you should also exit the position based on these factors. Regardless of whether the instrument is “overvalued” or “undervalued,” it may become even more “overvalued” or “undervalued” in the near future as markets may easily ignore fundamentals in the near term. Focus on your trading strategy and ignore the noise.
This article is brought to you by Forex4you.
