Are You an Investor or a Speculator?
At the end of each day, brokers on the floor of the New York Stock Exchange (NYSE) always clap at the ringing of the closing bell, regardless of whether the market ends up or down.
Why do you think they do that?
Why don't brokers cheer when the market closes higher and jeer when the market ends lower?
Well, it’s pretty simple: Because every time you make a trade, brokers still make money from commissions — no matter if you've made any money or not.
So, of course they cheer. Every day is a payday.
This truth is parodied in the 1983 Eddie Murphy and Dan Aykroyd classic comedy, Trading Places.
Randolph Duke: Some of our clients are speculating that the price of gold will rise in the future. And we have other clients who are speculating that the price of gold will fall. They place their orders with us, and we buy or sell their gold for them.
Mortimer Duke: Tell him the good part.
Randolph Duke: The good part, William, is that, no matter whether our clients make money or lose money, Duke & Duke get the commissions.
Speculating lowers your odds of building wealth. And it mostly serves to line the pockets of brokers. Investing, on the other hand, works for you.
But what's the difference between speculating and investing?
We often use the words interchangeably, but there are significant differences. For the answer, we can turn to the king of value investing: Benjamin Graham.
In his time-honored 1949 masterpiece, The Intelligent Investor, Graham writes:
An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.
According to Graham's definition above, investing is comprised of three elements:
- Analysis — the thorough scrutiny of a business' underlying soundness and value.
- Promise of the safety of principal — deliberate protection against steep capital losses.
- Adequate return — the aim for an acceptable, not extraordinary, return on investment (ROI).
Anything else is speculation.
An investor figures what share prices are worth based on the underlying value of the business. A speculator gambles that someone else will be willing to pay more for the stock in the future. They basically play the “greater fool” game.
As Graham puts it, investors determine “the market price by established standards of value.” Conversely, speculators “base [their] standards of value upon the market price.”
Confusing investing and speculating can be a costly mistake. We don't have to look any further than Bitcoin to see that.
Last year, the market went wild for Bitcoin and cryptocurrencies, even though few people fully understood them. Heck, people couldn't even agree if Bitcoin was a currency, a commodity, or some other form of asset. And in December, it all blew up in their faces:
In a 1972 interview with Forbes, Graham said, “Ask yourself: If there was no market for these shares, would I be willing to have an investment in this company on these terms?”
If your answer is yes, you're investing.
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There's no doubt that speculating is way more exciting. And if you get lucky, speculating can be extremely rewarding. But it's also one of the worst ways to build wealth over the long term.
Why? Because Wall Street, like casinos, tilts the odds so the house ultimately wins over time.
People often believe that the test of a sound investment is simply whether or not it brings in a return. If they make money, no matter how risky the play, people believe they're right. But a true investor has no interest in only being temporarily right. To reach your long-term financial goals, you must be right over the long term.
I once read a great analogy for how temporarily high returns aren't proof that success can be achieved over the long term. Let's say I'm driving to the beach, which is 150 miles away. If I drove at 50 mph, I'd be seaside in three hours. But if I drove at 150 mph, I'd be there in an hour.
If I made the trip at 150 mph and survived, does that make my approach to driving a sound idea? Would you try it, too, because you heard me bragging that it'd worked?
My point is that short streaks work... until they don't. And over a long enough period of time, they'll kill you.
Wall Street loves to downplay the durable virtues of investing in favor of the appeal of speculation. And we've already talked about why: “Duke & Duke get the commissions.” But the appeal of speculating is something that should be avoided.
Truth is, for better or worse, human beings love to gamble. But as value investors, we must keep that urge in check.
Don't fall for the glitz and hype of short-term gains from speculation; play the long game of investing.
Contributing Editor, Park Avenue Digest
As an editor at Energy and Capital, Luke’s analysis and market research reach hundreds of thousands of investors every day. Luke is also a contributing editor of Angel Publishing’s Bubble and Bust Report newsletter. There, he helps investors in leveraging the future supply-demand imbalance that he believes could be key to a cyclical upswing in the hard asset markets.