The difference between investment and speculation in the stock market is a lot like the difference between peppers.
On the one hand, you’ve got your everyday green bell peppers. They taste fine. They add a bit of flavor and body to sauces. They’re not bad in salads or sandwiches. But they’re the epitome of mildness. They’re more of a conduit for other, tastier foods than culinary superstars on their own. You probably forget you’ve had a bell pepper not long after you finish it.
On the other hand, you’ve got extremely hot peppers. We’re talking Scoville-busters like habaneros and Carolina reapers. They’re used to turn chicken wings into instruments of torture. You won’t forget one after you’ve had it. It can be exciting, and it might even taste good. But there’s a good chance your body will pay for it later (in ways we’d rather not describe).
Such is the gap for investing vs. speculating. Never underestimate the power of a food allegory.
One is a long-term strategy that doesn’t exactly scream “excitement,” but it keeps a portfolio in good health. The other is a quick-hitting strategy that can have an immediate impact on finances — but not necessarily a good one.
Let’s look at the merits and possible traps of speculation vs. investing. No napkins required.
Investment vs. Speculation: Defining Investment
When we talk about “investing,” we’re talking about a long-term strategy with extremely low risk, if any at all.
The investor seeks relatively safe companies and commodities that generate dependable, if unspectacular, profits over a long time. They usually focus on blue-chip, established corporations with global reach and presence. These are companies that consistently thrive and recover from economic hard times.
How Investors Analyze Stocks
Analysis plays a big part in investing. Professional investors take a deep look at companies’ underlying traits, market presence, and leadership. This is called “fundamental” analysis. They also look at past data, price movement, trading volume, and other current factors playing a role in the business. We call this “technical” analysis.
While both analytical styles are important, it’s fair to say fundamental analysis is a bit more meaningful for long-term investors. They’re looking for securities to “buy and hold” for at least a year, probably more. In return, the company will turn profits for the stockholder in the form of rising share values and (usually) dividend payouts.
Fundamental analysis directly relates to a company’s “intrinsic value.” This is defined as how valuable the company is in and of itself, regardless of its success on the stock market. It’s a bit of an abstract idea, but it can be supported by fundamental analysis.
Example of an Investment Stock
For example, let’s consider Johnson & Johnson. It’s as massive a healthcare company as you’ll find. It’s been around since the late 19th century. It’s grown steadily and surely throughout its entire existence. Its products include Tylenol, Band-Aid, Visine, Listerine, Bengay, and some awesome baby powder. There’s a J&J product in your home right now, we’re willing to bet.
Investors look at J&J and see that the corporation has increased its dividend payments for more than 50 years running. They also notice its diversified product line. And they recognize J&J has high intrinsic value — no matter how bad the economy gets, people are always going to need something J&J makes.
So the best strategy for J&J stock is to buy shares and walk away. Will J&J’s stock price ever enjoy a sudden, explosive uptick? Not likely, although it’s higher today than it’s ever been. But it’s not going to crash, either. It will be around for a long time and return sufficient profits if you hang onto your shares.
Defining Speculation
Speculation, on the other hand, is a short-term strategy with sky-high risk.
The speculative stock investor looks for high-profit opportunities to quickly cash in. The companies they pursue are generally new or unestablished businesses that might be poised for big breakthroughs. Oftentimes, they’re cutting-edge companies that are developing completely new products or services.
How Speculators Analyze Stocks
Speculators don’t necessarily go about their business blindly. Many of the most experienced speculators have some kind of analytical process. Fundamental analysis is especially vital in speculative trades: Market and industry conditions, leadership, business model, and so forth. There’s not much in the way of technical analysis with a speculative stock because there’s usually not a ton of historical data to look at.
But the appeal of speculation is more about the gamble. There’s a high-risk, high-reward quality to a speculative stock purchase. Shares are usually low-priced, which makes them attractive. If the speculator feels the company is on the verge of a quantum leap in value, they’ll buy in, hoping to capitalize on the profits. However, it’s more likely that the company will fail.
Speculators don’t hold onto their stock shares long. If and when the share price reaches a certain threshold, the speculator sells and pockets the rewards. Their perspective is short-term: A few months, a couple of weeks, or even one day.
Example of a Speculative Stock
We’re going to make up this example — any resemblance to an actual company is purely coincidental. Let’s say there’s a small company in California that’s developing and building a solar-powered car.
Some circles are excited about the prospect. The company CEO has a decent track record in the auto industry. There’s certainly healthy interest in vehicles that use alternative fuel sources. The car was the focus of a presentation at a big trade show, and everyone was in awe.
But others aren’t quite as thrilled. The company’s stock price has pretty much flatlined. There have been concerns about how good the car’s mileage will be. There’s resistance from auto retailers, and gasoline industry lobbyists are waging a fierce campaign against the vehicle. Some recent tests have uncovered a design flaw that has some engineers anxious.
A speculative investor gets wind of an upcoming announcement — actually, only the possibility of an upcoming announcement — that the company is going to partner with Toyota to manufacture the car. They feel this is going to be the defining moment that sends share prices into the stratosphere. So they buy lots of shares low expecting that to happen. Well, hoping — that’s speculative trading.
Pros of Investing
The biggest advantages of long-term investing are fairly self-evident. For the record, some of these advantages are:
Reliable Profits
Believers in long-term investing (like Warren Buffet) enjoy solid results year in and year out. They rarely (if ever) lose money on their investments. Share prices go up slowly but surely. Companies that pay out quarterly or annual dividends issue healthy checks on time.
Low Risk
Companies that long-term investors are attracted to are stable and secure. They have plenty of shareholders and cash flow. They have a strong foundation and dominate their respective markets. They often drive innovation if they don’t do it themselves. They’re proven entities, and therefore, low risks.
Confidence During Downturns
Companies worth long-term investments keep your portfolio safe in times of economic hardship. If you experience a downturn in value, it won’t last for too long. These companies have survived and endured multiple declines and recessions and can navigate bear markets successfully.
Low Maintenance
Generally, you don’t have to keep an overly watchful eye on long-term investments. They encourage a more passive form of investing, which some people prefer.
Lower Tax Rates
In all investments, capital gains — the amount you make when you sell shares for profit — are subject to taxation. Long-term investors are taxed according to certain gradients in taxable income, rather than the straight income that short-term investors are taxed against. Capital gains for long-term investors are usually taxed at rates 15% or lower.
Cons of Investing
It’s funny to say there are disadvantages to long-term investing. But we suppose we can come up with a few.
Time Investment
A long-term investment strategy takes a lot of time to pay off. Some investors, like retirees, may not have that much time to spend. Some investments can take years to turn recognizable profits.
Small Gains
Speaking of those profits, you’re likely to be underwhelmed when you see how much revenue your long-term investments generate. They’re going to be smaller gains that add up over time.
More Analysis
It pays to do your homework with long-term investments. That means a lot of research, reading, number-crunching, and projecting how your investments will play out years into the future. Some people don’t care for this work.
Pros of Speculating
Some of the advantages of speculative stock investing include:
Higher Profit Potential
If you get in on a speculative stock at the right time — and exit as soon as it’s practical — you can realize much bigger, immediate profits than a long-term investment offers.
Less Expensive Per Share
Speculative stocks are almost always cheaply priced. That makes it easier to snap up multiple shares. Having 500 shares in a cheap speculative stock that turns into the next Amazon? That’s going to end up well for you.
Support of Developing Companies
Upstart companies need capital to stake their place in the market. Speculative investors tend to spend often, creating more liquidity in these small companies and driving innovation. They can also make these startups more appealing to bigger institutions that are thinking about financing them.
Excitement
C’mon — it’s fun. An involved speculator can get great personal satisfaction from short-term trading if they do it right.
Cons of Speculating
Some of the disadvantages to speculation include:
Huge Risk
There’s a much bigger chance a young company will fail than succeed. According to Investopedia, the startup failure rate in 2019 was 90%. Over half of these failures happen within the first two years of existence.
More Volatility
Speculators need stomachs of iron. The companies they invest in typically experience intense fluctuations in price before they finally take off — which, of course, they may never do.
More Susceptible to Economic Downturns
Speculative stocks tend to do better in bull markets because there’s more money in general funneled into investments. But in bear markets, that trading volume goes down. Investors look for safe havens, which speculative stocks are not. This can spell instant death for a startup.
Higher Tax Rates
Speculators must pay higher taxes on their capital gains — as high as 37%.
Investment vs. Speculation: Which One’s for You?
There’s a great difference between investment and speculation. But that doesn’t mean they can’t co-exist peacefully.
The global economy needs both long-term investors and speculators. Long-term investors reinforce the foundation the economy needs to sustain itself. Speculators help to keep innovation and invention alive.
Your portfolio may benefit from a healthy blend of the two styles. Mixing long-term investments with a side of speculative stocks diversifies your holdings. Diversification is one of the surest ways to mitigate the risk of major economic loss. If you can stomach the risk of speculative stocks, they can turn out to be strong support for your more reliable holdings. And vice versa.
Most analysts believe a good strategy is to devote 90% of your portfolio to long-term investment strategies and 10% to speculative ones. That’s not bad. More aggressive investors might increase their percentage of speculative stocks to 15% or so without seeing too much fallout.
Whatever you decide, do all your homework and due diligence with both investments and speculative trades. You’ll lay a great groundwork for ongoing economic health — with just enough adventure to keep things interesting.
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