Investing and Speculating

Investing and speculating are two vastly different approaches through which you can generate returns from the financial markets. Investing involves purchasing financial instruments, expecting them to increase in value or generate income over time. Speculation, meanwhile, involves purchasing and selling financial assets over the short term to generate profits.

Understanding the difference between investing and speculating is crucial to making well-informed decisions. In this article, we are going to delve into the concepts of investing and speculation and unearth the differences between these two approaches.

What is investing?

Investing is a wealth-creation approach where you invest your money in financial securities such as stocks, bonds or mutual funds with the expectation that it will grow in value over time.

Investors who use this approach usually have a long-term perspective and hold onto their assets for extended periods, aiming to build wealth gradually. Some examples of investment options include bonds, equity stocks, mutual funds, Exchange-Traded Funds (ETFs), real estate, annuity plans, bank deposits and money market instruments.

What is speculating?

Speculating involves taking up positions in an asset and expecting it to move in a particular direction. Unlike investing, speculation usually disregards the fundamentals of assets in favour of high-risk, short-term bets.

Traders following this approach are usually concerned only about generating profits quickly, even if it means taking on high risk. They thrive on volatile market conditions and use the momentum of the market to capture price movements. Some examples of speculative investment options include derivative contracts like futures and options, penny stocks, cryptocurrencies and commodities.

Also read: What is 80-20 Rule in mutual fund

Investing: An example

Let us now take up a hypothetical example to understand how investing works before moving on to the differences between investing and speculating.

Assume you are a 23-year-old individual wanting to accumulate a large enough corpus for retirement by the time you reach 60 years of age. You have almost 37 years to accumulate wealth. After carefully analysing the various investment options available and their fundamentals and other key metrics, you decide to invest in an equity-focused mutual fund via a Systematic Investment Plan (SIP).

Through the SIP investment, you plan to invest Rs. 10,000 each month consistently for the next 37 years. Assuming that the average rate of return of the fund is 9% per annum, you would accumulate approximately Rs. 3.57 crore at the end of your investment period.

Speculation: An example

Before moving on to the comparison between investing vs. speculating, let us quickly look at an example to better understand this concept.

Assume you wish to make quick profits. You identify a particular stock that has posted a less-than-ideal quarterly financial performance. Speculating that the price of the stock would fall in response to this, you decide to short-sell 1,000 shares at Rs. 85 per share.

As you expected, the price of the stock fell to Rs. 75 per share on the same day. You square off your position immediately and get a profit of Rs. 10,000 per share (1,000 shares x Rs. 10 per share).

Also read: What is portfolio rebalancing?

Examples of speculative investments

Speculative investments generally involve high risk but also provide high rewards if market movements are favourable. Here are some of the most common speculative investments that traders usually opt for.

• Penny stocks
  Penny stocks are shares of small-scale companies that trade at very low prices, often below Rs. 10 per share. Since the price movements of penny shares are often very volatile and are not based on strong fundamental or technical factors, they are considered to be speculative investments.
• Derivative contracts
  Derivative contracts are financial instruments that derive their value from an underlying asset. The underlying asset can be an equity stock, a market index, a commodity, or even a currency pair. There are two different types of derivative contracts available: futures and options. Derivative contracts use leverage, which enables traders to control large positions by depositing a fraction of the trade value as a margin.
• Art and collectables
  Art and collectables are popular alternative investments that are speculative. The value of these assets is not based on any fundamental factor but rather relies on the perceptions of interested individuals.
  

Crucial differences between investment and speculation

As an investor, you must understand the differences between investing and speculating to make well-informed purchase decisions. Here is a detailed overview of some of the crucial factors differentiating the two approaches.

• Risk management measures
  Although investment and speculation require the use of risk management practices, there is a major difference between the methods employed. For example, investors use techniques such as diversification and asset allocation to protect their investments from adverse market movements. Speculators, on the other hand, use risk management measures like stop-loss orders and position sizing.
• Research and analysis techniques
  Investments require a comprehensive analysis of fundamental factors like financial statements, industry trends, and macroeconomic indicators to make informed decisions. Speculation, however, involves focusing on the technical factors of an asset, like price patterns and market trends, to predict short-term movements.
• Susceptibility to emotions
  Investments are not susceptible to emotions since investors usually tend to maintain a more disciplined approach, persisting with their investment strategy even when the markets are turbulent. Speculation, meanwhile, is very susceptible to emotional decision-making due to short-term market volatility.
• Use of leverage
  Leverage allows for the control of a large position with just a small amount of investment. Investments usually do not use leverage, whereas speculation often involves heavy leverage in the form of margin trading to amplify potential gains. However, while the use of leverage can increase the profit potential, it can also significantly magnify losses if the market moves unexpectedly.
• Income generation
  Long-term investments usually generate passive income in the form of rent, interest, or dividend payments. This passive income, when reinvested, often boosts the wealth-creation potential of investments. With speculation, there is no passive income, forcing traders to profit from price movements.
• Impact on the market
  Large-scale investments, which are often carried out by institutional investors, can stabilise the markets by keeping volatility in check. Speculation, especially when conducted on a large scale, can lead to a spike in market volatility and the formation of an asset bubble.
• Regulatory scrutiny
  Although investment activities are also subject to scrutiny, market regulators often tend to view them more favourably. Speculative activities, meanwhile, are subject to strict regulatory scrutiny due to their increased potential for losses and their ability to quickly destabilise markets.

Also read: What is inherent risk?

Investing vs Speculating: A detailed comparison

Here is a table outlining all of the key differences between investment and speculation that set them apart from one another.

Speculating vs Investing: Which one to choose?

Now that you are aware of the differences between investing and speculating, which of the two approaches should you choose? Here is something that can help you make a decision.

The choice between speculating and investing largely depends on the following four factors: financial goals, risk tolerance, investment horizon, and personal circumstances. Investing is generally more suitable for those looking to create wealth over the long term without taking on too much risk. The approach is ideal for major life goals such as retirement planning, home purchases, and financial independence.

That being said, speculation might be more suitable for those looking for short-term profits, even at the cost of taking on high risk. However, it is important to note that speculating requires a significant time commitment since it involves constantly monitoring the markets for short-term opportunities. This makes the approach ideal for individuals who are comfortable with the possibility of significant losses in pursuit of quick gains and can carry it out on a full-time basis.

Also read: Active vs passive funds

Conclusion

Investing and speculating are two entirely different approaches to wealth creation. The choice between the two must be based on your financial goals, time horizon and risk tolerance. If you have moderate risk tolerance and are looking for steady, long-term growth, investing may be the right choice. On the other hand, if you are risk-aggressive and seeking quick profits, you could consider speculating.

If long-term investing is what you prefer, the Bajaj Finserv Mutual Fund Platform can help. You can find more than 1,000 mutual fund schemes from some of the leading AMCs in India. Additionally, you can also compare mutual funds with one another and choose the one that fits your requirements.

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