When you decide to make a trade are you methodical or impulsive? It’s important for every trader to understand that your trading decision-making process can have an impact on your portfolio’s overall volatility and performance. Let’s examine two main approaches: investing and speculating.
An easy way to differentiate between investing and speculating is to look at the amount of risk involved and the time horizon. Speculation is generally high-risk and short-term focused. On the other hand, investing is typically considered lower-risk and longer-term focused.
The great value investor Benjamin Graham eloquently explains:
“The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels, at which he would be wise to buy, and high price levels, at which he certainly should refrain from buying and probably would be wise to sell.” – Benjamin Graham, The Intelligent Investor1The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements.Click To Tweet
A Closer Look At Speculation
What are some of the reasons that could motivate someone to trade based on speculation? Volatile or inefficient markets could present opportunities to make short-term profits. Speculators may rely on technical analysis and study historical prices and volumes to anticipate movements in a stock’s price.
Tips, rumors, news and gut instincts could also compel someone to trade on speculation. For example, let’s say a trader gets wind that a company is likely to report greater than expected earnings. He may decide to buy shares before the company’s earnings announcement in hopes to make a quick profit on a jump up in price. A speculator’s instinct to buy a stock could also be triggered if he or she notices a steady pattern of new highs on heavy volume.
Some people compare speculating to the high stakes of gambling. But, just because someone trades on speculation does not mean they are reckless. After all, unlike in gambling, seldom do you immediately lose 100% of your investment if you are wrong.
Experienced speculators make educated trading decisions and take on added risk in hopes of receiving high rewards. Speculators are focused on the potential of earning money on sudden price movements, not on the actual ownership of companies.
Novice traders should be careful not to fall for get-rich-quick schemes or make rash investment decisions. Although it’s possible to make quick profits on speculation, inexperience and a lack of due diligence are likely to result in losses. The transaction costs of high-turnover buying and selling are another aspect to keep in mind – these expenses can add up quickly and reduce your profitability.
Since speculating involves taking calculated short-term risk in order to maximize rewards, it is also common for speculators to place trades on margin versus cash. Trading on margin simply means taking out a loan with a broker dealer, which can be used to place trades. Margin accounts are typically maintained separately from traditional cash accounts and carry the risk of amplified losses.
For example, let’s say you borrow $1,000 to buy $2,000 of a stock. If the stock goes down 50% and there’s a margin call, you will have essentially lost 100% of your investment. Add in the cost of interest charges and you could actually lose more money than you put in. Hence, be very careful before going on margin.
The Methodical Approach Of Investing
Unlike speculators, investors are focused on the long-term and strive to make moderate returns. As a result, their portfolios have average or below-average risk. Investors typically hold on to their stocks even during volatile periods if the fundamental analysis of the investments are undisturbed.
In other words, short-term price swings do not motivate investors to trade with the same urgency as they do for speculators. However, since investors are focused on the long-term ownership in companies, price drops could incentivize investors to add to existing holdings if they believe the fundamentals are still sound.
Investing involves carefully researching business fundamentals such as financial strength, market positioning and management’s track record. Investors typically do not rush into or out of a stock like a speculator. Active investors closely review quarterly earnings announcements, listen to company management speak, and review industry reports before making transactions.
It’s also common for investors to diversify their portfolios to help manage risk and refrain from high turnover. Famous investors like Warren Buffett typically hold stocks for multiple decades, avoid highly volatile industries like technology, refrain from trading based on hearsay, and invest in companies they thoroughly understand.2 Since trading on margin is risky and can become very expensive over time, investors typically place their trades in cash too.
If you prefer a more stable, cautious, and analytical approach to building wealth, investing could be a better fit for you versus speculation.
Put Your Cash To Work
Although there are many differences between investing and speculating, sometimes a trading decision could involve a bit of both. However you decide to invest, putting money into the markets can be an exciting and rewarding experience.
Got cash? You can put it to work today at Motif Investing. All it takes is $250 to get started.
1 Matson, Mark, “Speculating Is Not investing,” Forbes, July 30, 2010.
2 Basu, Chirantan, “Difference Between Speculating And Investment,” Zacks Finance 2015.
Investing in securities involves risks, you should be aware of prior to making an investment decision, including the possible loss of principal. An investment in individual stocks, or a collection of stocks focused on a particular theme or idea, such as a motif, may be subject to increased risk of price fluctuation over more diversified holdings due to adverse developments which can affect a particular industry or sector. Investments in ETFs can include those with a narrow or targeted investment strategy and can be subject to similar sector risks than more broadly diversified investments. Motif makes no representation regarding the suitability of a particular investment or investment strategy. You are responsible for all investment decisions you make including understanding the risks involved with your investment strategy.