The difference between speculation & investing

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All investments carry some risk, but the difference between speculating and investing can illustrate the level of risk involved.

Speculating often describes scenarios when there’s a high chance the investment will deliver losses but also when the investment could result in a high profit. In contrast, investing generally refers to situations when an individual researches an asset and puts money into it with the hope that prices will rise over time a reasonable amount.

The difference between speculating and investing can be nuanced and a matter of opinion. But when traders are speculating, they can wager on higher-risk markets such as cryptocurrencies, commodities or shares of smaller companies. They may use investment tools such as options or futures. Meanwhile, in investing, individuals may buy or hold stabler assets in their 401(k) portfolios or mutual funds.

Here’s a deeper look into speculation and investing, along with examples.

Related: Understanding stock volatility

Probability in Speculation vs. Investing

One way to differentiate between investment and speculation is through the lens of probability. If an asset is purchased that carries a high likelihood of profit, it’s an investment. If an asset carries a higher likelihood of failure, it is speculation.

It helps to have some historical data that people can base their assessment on. While historical data cannot necessarily predict the future, it can provide a foundation for understanding probabilities. For example, with approximately 100 years of rolling data of U.S. stock market returns, it is easy to say what “typically” happens over a five-year or 20-year period.

In common terms? A telltale sign of speculation is the high potential for a person to lose all money invested in an attempt to make the really big bucks.

Historical Data in Speculation vs. Investing

Sometimes the nature of the investment itself can be speculative. Cryptocurrency is inherently speculative because there is little way to know what will happen in the future with both returns and regulation. The history we can study to analyze trends and outcomes is sparse.

It’s possible to both invest and speculate within an asset class. There are certainly ways to invest and speculate within the stock and real estate markets. Often the difference is in the investing time horizon, or how much time an investor is willing to commit to an investment.

Here’s an example. A long-term commitment to a broad stock market investment, like an equity-based index fund, is generally considered an investment. Historical data shows us that the likelihood of success over long periods, like 20 years or more, is very high.

Compare that with a trader who purchases a single stock with the expectation that the price will surge that very day (or even that year), which is more difficult to predict and has a much lower probability of success.

Examples of Speculation vs. Investing

Assets that are thought of as investments include the stock market, mutual funds, U.S. treasury bonds, high-grade corporate bonds and real estate.

Assets that are almost always considered speculative are junk bonds, options, futures, cryptocurrency, forex and foreign currencies and investments in startup companies.

Sometimes it isn’t as simple as saying that all investments in the stock market or in exchange-traded funds or in mutual funds hold the same amount of risk, or are “definitely” classified as investments. Even within certain asset classes, there can be large variations across the speculation spectrum.

Speculation vs. Investing in Stocks

First, consider an investment in an individual stock. Not all companies, and therefore not all stocks, are created equal. A stock’s level of risk will, more or less, be commensurate with the riskiness of the underlying business. Simply being a stock doesn’t tell us the whole picture about the investment.

Consider an investment in the stock market via an investment fund, like an ETF. Generally, an ETF invests across some market in a broad and low-cost way. But ETFs cover many different markets, all of which carry varying degrees of risk.

For example, some ETFs invest in the entire U.S. stock market and some track-only micro-cap stocks, which are the stocks of very small, highly speculative companies. Neither the fact that the investment was of the stock market nor bundled via an ETF could fully clue us in to the nature of the investment’s risk.

Also, how an investment is being used is as important as the investment itself. It is two very different things for an investor to trade an ETF and to buy and hold an ETF, even if it is the same ETF in question.

Day traders are generally engaging in speculative behavior. They pay money to make bets on what will happen to the price of an investment (like a stock or ETF) over a short period.

If traders place a market order, they pay whatever the current market price is for the stock they’re buying or selling. But by using limit orders, traders can name their own buy and sell prices. A novice trader may not be ready to start setting limit orders.

A Personal Matter: Risk Tolerance

It will always be up to individuals to decide for themselves whether to speculate. This will require an internal examination of their own risk tolerance.

When looking at risk tolerance, it may be helpful to view it within the frame of a person’s financial situation and goals.

Imagine Eve, who has yet to start investing but is excited to get started via a Roth IRA. She wants to build a nest egg for her future by making contributions each month. She doesn’t feel as though she is in a financial position to take an exorbitant risk, so she chooses to invest.

Next, take Alex, who has recently sold a tech startup company, which will cover his living expenses and beyond. He is financially comfortable and looking to take some speculative risk with a chunk of his earnings. He chooses to invest in cryptocurrency and another tech startup.

No one should tell another person that they should speculate. In fact, if investors find themselves in a position where someone, a financial professional or not, is encouraging them into an investment that sounds too risky — or too good to be true — it might be time to head for the hills.

The adage is usually true: If something sounds too good to be true, it probably is.

The Takeaway

Once investors have taken inventory of the types of risk they are willing to take, they can build a portfolio to match. Those who are willing to take more risk and are seeking outsized gains may find speculating best suited for them. Investors who want to see less volatility in their portfolios and potentially conduct fewer trades may prefer a buy-and-hold strategy.

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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

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