Investing, not Speculating

Investing, not Speculating

Investing creates real wealth. This wealth is created when natural resources, skilled labor, intellectual capital, and financial capital is skillfully combined in an enterprise to generate profits. As investors, we want to capture some of that wealth and make it our own. We do this by providing the financial capital part of the equation. We can provide this capital in exchange for an equity interest (stocks) or as a creditor (bonds). When we hold stocks, we expect them to appreciate in value and, in some cases, receive dividend income. When we hold bonds, we expect periodic interest payments and eventually the return of our original capital. This is how capitalism works, and it has been working very well for a long period of time. The bulk of personal financial wealth in the world has been created through this time-tested process.

Speculating is not investing. It involves making a bet against someone else that the value of something is going up or down, usually on a short-term basis. Because there are two sides to every bet, there is a winner and a loser. It’s a zero-sum game. At the end of the day, no real net wealth is created, other than those who receive a fee for making the market where the participants place their bets. Of course, there is value to speculation because it can make our markets more efficient, but as we have learned recently, this is not always so. To win as a speculator, you must be right many more times than you are wrong over a long period of time. This can be a very daunting and expensive task.

Not all speculation is bad, and not all investing is good. That being said, we have a much better chance of financial success when we act as long-term investors the great majority of the time, and occasionally use a small amount of conservative speculation to hedge our bets and reduce volatility.

Are you investing or speculating?

It is important to recognize when we are investing versus when we are speculating. For example, when we try to time the markets by selling stock mutual funds because we think the market will go down this year, we are speculating. When we buy and hold a stock mutual fund because we believe that the companies inside the fund will grow and prosper over a long period of time, we are investing.