This is a common question that I get from people who are new to investing in the capital markets. They commonly wonder what is the difference between investing vs speculating? The best way for me to explain this is the amount of risk that an investor is willing to take on. An investment will be a low risk where speculation is a riskier investment style.
I did a search for the definition and I feel like the majority of the things I read are incorrect on this subject.
What Speculation Isn’t:
- Many of these definitions claim there is an arbitrary time frame that makes you an investor or speculator. This isn’t a relative fact to understand the difference between these two terms. In fact, a bond that doesn’t mature for 30 years is riskier than one that matures within one year.
- Trading and Speculating are not the same things. These two terms are not interchangeable. I define a trader as someone who has a set time for entry, exit, with a chosen risk to reward ratio. A speculator doesn’t have all these attributes.
- There isn’t a perfect one size fits all definition. There are many ways to look at these definitions because they are subjective. Remember that your tolerance for risk and financial education will be a defining factor of what is speculative for you vs investing.
What is the difference?
I briefly explain the attributes about these two styles below. This would be the difference between a speculative buy or investment grade buy in the stock market. I have a page that introduces you to common stock.
- Mature Company (Older in age)
- Proven Management
- Normally mid-cap or larger companies
- Controls a Large Market Share
- Pays a Dividend to owners
- In an Established Sector
- Start-up or Young in Age
- Management is inexperienced
- Controls a small percentage of the overall market
- Normally are a Small Cap or Mid Cap stocks
- Is classified as a growth stock
- Sector is relatively new
An Example of the Difference
For my example, I will talk about two stocks that I was analysing and one of these I would consider an investment and the other would be speculation. These two happen to be in the same sector but speculative stocks can be in a new sector. Think of Amazon which is a growth stock. They are relatively new and at one point they would have been considered very speculative.
Coke vs Colt
There really aren’t too many large soda producers that are around. There are mostly 3 if you include Coke, Cott, and Pepsi. At one point, I was trying to make the decision whether to buy some KO or COT for my stock portfolio. This was a suitability issue for me where I wanted to see portfolio growth so I choose COT over KO because it is definitely more speculative.
The reason why I say Coke is an investment is the fact that they are an old and mature company who has paid a dividend for years. Anther important thing to note is that Coke controls the Soda Beverage market. You can’t go anywhere without seeing coke products in the United States. The most important thing is that they have a proven management system.
When we contrast COT to this they are a small company with fewer resources when you compare them to COKE. Their stock is extremely volatile and there is a risk of receiving no dividend when you invest in companies like this. They are the underdog when it comes to the amount of market share they control.
From reading this analysis, you can understand what makes COLT a more risky buy then KO and why one is considered speculation and the other is an investment. You are probably wondering what happened over the time frame that I owned shares of COLT. Overall, I had a gain of 20% and received a 3.2% yield from dividends received over the year. You would have made a small gain from KO over this timeframe.
Other Investment Types
I mostly talked about the differences when it comes to equity investments in this post. You might be wondering about bonds, notes, or preferred stock. There is investment grade or speculation grade’s in these investment types too.
Think about cooperate bonds as an example, think about the S&P rating on these to give you a guideline on how risky they are. An investment grade bond will have a higher rating and pay a lower interest rate where a speculative bond (Junk Bond) will have a low rating and pay you a higher interest rate.