The Difference Between Speculating and Investing

Warren Buffet (who, at several points over the past decade, was the richest man on the planet) doesn’t keep what he does very secret. One of his best suggestions is to invest, not to speculate.

What’s the difference between speculating and investing? Isn’t it the same, since no-one really knows if the market will go up or down?

The difference is really found in why your are investing in a stock (or fund, or property, etc).

  • If you believe that the value of the stock itself will go up (at which point you’ll sell and make a profit of the difference between what you bought it for) this is speculating.
  • If you buy a stock, mainly on the long-term dividends you’re likely to receive from ownership of the stock, you are investing.

Of course, investors also know that the stock price could rise as well, in which case they’ll make even more money.

Investors…

  • Expect their money to be unavailable for years – not months or days.
  • Are interested in the income from an asset, not the value of the asset itself – e.g. the apples, not the apple trees.
  • Are willing to spend time researching where they put their money, much more than your average person who just looks at graphs going up and down and look for patterns.

Speculators…

  • Want to make as much money as quickly as possible
  • Are interested in the temporary value of an asset, not things like dividends
  • Have little of no knowledge of things like a company’s management team, medium term strategy, etc. All they are interested in is its value.

Just like the lottery, the odd tales of people making a massive quick profit encourage other people to take part in speculation – despite the fact that most will lose out.

One of Buffet’s famous quotes is “Be greedy when others are fearful. Be fearful when others are greedy” Another way to think about this is “buy when others are selling frantically, sell when others are buying frantically.”

This doesn’t just apply to the Stock Market. It also applies to things like house prices. In the early years of the 21st century, many people in the UK and USA saw house prices going up and thought that they could make some money. So, a lot of people bought houses they couldn’t really afford – which drove prices up even more. This created a speculative bubble (when a particular type of investment has become over-inflated, and will at some point, burst). Sure enough, when it started going downhill fast, people tried to sell their houses, but no-one wanted them and prices crashed.

It’s human nature to not want to miss out on a good deal, and that’s one of the main reasons that these bubbles appear. However, when it appears people may actually lose money, that’s when they try to sell quickly – which causes prices to crash. It’s very difficult to resist the temptation to get caught up in a bubble, since most people think that they will get out just in time before it crashes. Few do, though.

Investors often use a rule-of-thumb called the price/earnings ratio to determine if a stock is over or undervalued. Very simple, it says take the price of a stock (e.g. 200pence) and divide it by the dividends (e.g. 20pence) and you have a number (e.g. 10). This number  represents the number of years it would take to get back the original investment (presuming the dividend amount remains the same for years… which it won’t). Traditionally, if the number is above 15 it is overvalued, under 15 and it’s undervalued.

What has further complicated things in recent years is that many newer companies (often high-tech) don’t make money for years, but they are worth billions. Although this would indicate speculation is at work, investors could also have good reason to believe that the company will soon be making health profits.

One final point is that speculation (using Buffet’s definition) presumes no unique knowledge – it’s equivalent to gambling, since the price could equally go up or down. However, if you have specialist knowledge of an industry (“hunches” don’t count, and insider trading can land you in prison) the odds are not 50/50.

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