Investing and speculating are two similar but different terms. While one bases its decisions on well-argued foundations, the other carries out its operations with much more risk and uncertainty. Let's see then how investment differs from speculation.
What is investing
Investment can come in many different forms, through methods based on money, time or energy. In the financial sense of the term, investing means buy and sell assets such as stocks, bonds, exchange-traded funds (ETFs), mutual funds, and a variety of other financial products. Investors expect generate income or profits through satisfactory profitability of your capital assuming an average or below average amount of risk. Income may take the form of an appreciation in the value of the underlying asset, periodic dividends or interest payments, or a full return of your spent capital. Most of the time, investing It is the act of buying and holding an asset for the long term. To classify as a long-term holding, the investor must hold the asset for at least one year.
investment example
Let's put a large stable multinational company in context as an investment example. This company may pay a constant dividend that grows annually and may have low trading risk. An investor can choose to invest in this company for the long term to obtain a satisfactory return on his capital while assuming relatively low risk. Furthermore, the investor You can add several similar companies in different industries to your portfolio to further diversify and reduce your risk. Analysis and investigation They are a key part of the investment process. It is about evaluating different assets, sectors and patterns or trends that occur in the market. Investors can use tools like fundamental analysis or technician to choose your investment strategies or design your portfolios. By using fundamental analysis, investors can determine what factors affect the value of securities, from microeconomic to macroeconomic factors. Technical analysis, on the other hand, uses statistical trends such as stock prices and volumess to find opportunities in the market.
Study of dividend reinvestment (red) vs non-reinvestment (brown) in Coca Cola (KO) shares. Source: Joshua Kennon.
What is speculating
Speculating is the act of putting money into financial projects with a high probability of failure. The speculation look for abnormally high returns of the bets that can go in one direction or the other. While speculation is compared to gambling, it is not exactly the same, as speculators try to make an informed decision about the direction of their trades. However, the speculative risk inherent in the transaction tends to be significantly higher than average. These traders buy assets with the hope that they will be held for only a short period before selling them. They can frequently enter and exit a position.
Speculation Example
Let's put a volatile gold mining company in context as an example of speculation. This new gold mining company has the same short-term chance of skyrocketing from the discovery of a new gold mine or declaring bankruptcy. Without news from the company, investors would shy away from such a risky operation. However, some speculators can they believe that the gold mining company will find gold and you can buy its shares by following your instincts. This instinct and subsequent investor activity is called speculation. Speculative trading has its downfalls. When there are inflated expectations of growth or price action for a particular asset class or sector, these will increase. When this happens, the trading volume increases, which eventually leads to a bubble. This happened with the dotcom bubble. Investment in Internet companies grew exponentially in the late 1990s, and valuations rose rapidly. The market crashed after 2001, causing major tech companies to lost a large part of their value and many others were eliminated.
Dotcom bubble burst graph. Source: Wikipedia.
Speculation strategies
Speculators can carry out many types of trades and some of them include:
- Futures Contracts: Buyers and sellers agree to sell a specific asset at an acceptable price at a predetermined point in the future. The buyer agrees to purchase the underlying asset once the contract expires. The futures contracts They are traded on exchanges and are commonly used when trading commodities.
- Buy and sell options: In a put option, the owner of the contract has the right, but not the obligation, to sell any part of the security at an agreed upon price in a specified period of time. A call option, on the other hand, allows the contract owner to purchase the underlying asset before the contract's expiration date at a specific price.
- Short sale: When a trader makes a short sale, he or she speculates that the price of an asset will decline in the future and then takes a position.