Differentiating between investments and speculations is more nuanced than distinguishing investments from expenses. Speculations are often inappropriately referred to as investments with the main similarity being both are purchased with the intent of profiting. The allure of speculations is their potential for quick and dramatic profit, but quick and dramatic losses are more probable.
Let’s think of investments and speculations on a scale of one to ten. This list is not exhaustive but should serve to illustrate:
1. Cash in a bank account or Guaranteed Investment Certificates|
3. Blue chip corporate bond
4. Blue chip dividend stocks
5. General corporate bonds
6. Stocks in established companies
7. Stock options, gold
8. Stocks in start-up companies
10. Gambling and lottery tickets
Each category has within it a significant range of risk and reward, but in general the lower categories have low risk to initial capital but also low returns. Higher returns are achieved moving up the scale but that comes with some risk to initial capital. Generally, the lower on the scale the more likely any loss will be temporary and the higher on the scale the more likely declines could be permanent. The highest categories have the potential for dramatic gains or losses to initial capital and are speculations.
It is generally perceived that the higher the risk the higher the reward, but I would argue that the lower categories have large hidden risks of taxation and inflation. In many cases, their real return will be negative.
My investment strategy falls into the middle categories, where I believe long-term returns are best, and loss of initial investment, while probable on some stocks, are unlikely from a long-term perspective with a well-selected group of companies. There is, however, the potential of temporary swings in values as we experienced this past spring. But where do we draw the line between investments and speculations?
This depends partially on a person’s comfort level, and partially how the tool is used. Some are so fixated on a potential loss of initial investment they stay in cash and GICs, accepting much larger risks of negative real returns and erosion of purchasing power.
Others are flippant with gambling tendencies, fully believing the higher the risk the better the reward. However, the highest risk categories can easily lead to results even worse than the lowest risk categories. Contrary to conventional wisdom, I would suggest the middle categories represent the lowest real risk as there is limited risk of negative real returns or of losing initial capital with a good portfolio structure. Any one stock could decline but the portfolio will build over time.
The other part of drawing the line is how a tool is used. Day trading a blue-chip stock is speculating rather than investing, despite blue-chip stocks being in a lower risk category. Research indicates less than three per cent of day traders make money, despite all the hype you can quit your job and get rich quick.
Options are considered very high risk and speculative. As a standalone strategy they are, but when used as portfolio insurance or in conjunction with a good stock strategy, they can enhance returns with limited additional or even reduced risk levels.
Risk/reward charts or scales like the one above, usually have one category for stocks, but I have placed them into three different categories as there is a wide range of risk amongst stocks. I rarely purchase high-risk stocks in start-ups. There are lots, but few will succeed long term. It’s a bit of that needle and haystack thing.
Purchasing shares for the purpose of participating in the long-term success of a company is investing. Purchasing with the intent of flipping to a higher bidder regardless of financial success of the company is speculating.
Many will categorize gold and cryptocurrencies together, but gold has a track record of a few millennia as a store of value, whereas cryptos have a few years. They can both be looked upon as protection against government malfeasance, as one could argue is currently occurring.
While the line between speculating and investing is slightly blurred, they are different and it’s important to make the distinction. Speculations are often described as investments because the word has a more positive connotation. But let’s not fool ourselves.