What’s the difference between investing and speculating? While they may share several attributes, there are five key factors that set them apart – along with one important mistake that should be avoided at all costs.
To paint a clearer picture, imagine two people with different approaches: one who is more comfortable adopting a "buy and hold" approach where financial instruments are bought and held for a long time, and another who prefers scalping and is constantly opening and closing positions in seconds.
But it’s often not as clear cut as that. What about someone who holds a position for eight months and then sells it? Is that considered investing or speculating? Let's take a closer look and find out.
The Time Horizon
Investing usually takes place over longer timeframes, the most obvious thing that sets investing apart from speculation is the time horizon. As it involves putting money to work for years and even decades, an investment is a bet on the overall appreciation of the asset's value across the duration.
However, it’s not just a case of waiting with no gain, as investments can generate a stream of additional income in the form of stock dividends or bond coupon Payments .
On the other hand, speculators look towards the short-term appreciation and depreciation of the asset's price to make quick profits and aren’t too bothered by the potential income which could be generated in the long run.
Use of Leverage
In most cases, investors do not use leverage. Since investors are willing to endure the ups and downs of the market over several years, using leverage does not make sense as it makes the position vulnerable to downside moves – as well as incurring a cost.
As for speculators, leverage is extremely important as it gives them the opportunity to boost any potential profits. Although using leverage incurs a cost, it’s usually worthwhile as positions are often closed within days or weeks or, in the case of day trading, within just a single trading session.
Potential to Earn
This is a point that is often debated. Investors and speculators alike would steadfastly insist that their way is the most effective method to generate profit.
In the past, while speculation allowed traders to gain significant short-term profits, it all came at the cost of significant commissions from active trading. These days, commissions are much lower and sometimes even commission-free, making it much more attractive for active traders.
To be clear, there’s no guarantee of quick profits, but if an investor's performance is consistent and income is regularly reinvested, he may enjoy great results in the long run.
In simple terms, speculation is for those hoping to see quick results, while investors aim to make money in the future. Either way, you’ll need the necessary knowledge and discipline to succeed.
Managing Risks
At this point, you may have come to the conclusion that speculation has a higher risk level, and you’d be right. One of the reasons is because speculative trades tend to involve leverage – and that increases risk.
Speculation is also based on shorter timeframes where random factors can easily affect market behavior.
Imagine this: A sudden market-wide sell-off is sparked by news that is unrelated to the instrument, resulting in temporary panic that pushes a trader out of a speculative position. However, an investor who hangs on to this position can enjoy future upside when the instrument gets back to its natural levels.
Thankfully, it isn’t hard to manage risks, but it ultimately depends on the capabilities of the trader or investor rather than on external forces.
How Decisions Are Made
Investors typically make their decisions based on fundamental analysis. Some investors use technical analysis to find better entry points, but technical analysis does not serve as the basis for an investor's decision.
In the long run, fundamental factors are crucial, while technical factors are more important in the short run. As investors enter long-term positions, they must make their decisions based on fundamentals.
Not surprisingly, technical analysis is the main tool for speculators who deal with shorter timeframes. Although some traders consider fundamental factors, many speculative traders base their decisions solely on price action and general market conditions.
Mistakes You Should Avoid
Now that you are able to distinguish between investing and speculation, let’s explore the biggest mistake made by both investors and speculators and how we can avoid it.
There’s just one simple, but often overlooked rule: Use only one method for both entry and exit.
This might sound easy, but it’s common for traders to break this rule and suffer poor performances.
Often, a trader might enter a long position based on technical factors. But rather than closing the position when the trade does not go as expected and absorb a small loss, many traders convince themselves that they are "investors" and holds this position for a much longer period than is prudent. Although they might get lucky and see results swing their way, they may also turn into "bag holders", a term used for poor investors watching their position slip in an irrecoverable downside trend.
Investors are not immune to this either, as it might be tempting for some investors to grab quick profits when an instrument's price rises, which turns them into speculators. However, if their original analysis was correct, the price of the instrument should continue to rise over time, meaning that they would have missed out on a huge chunk of gains!
Thankfully, this can be easily corrected. Whenever you enter a position based on fundamental analysis, ensure that you have the discipline to exit it when the fundamentals change. Don’t be distracted by the market action and focus on fundamentals instead.
Likewise, when you enter a position based on technical factors, you should also exit the position based on these factors. Don’t be swayed by whether the instrument is "overvalued" or "undervalued," as it may become even more "overvalued" or "undervalued" soon as markets can ignore fundamentals in the near term. Ignore the noise and stay focused.
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