What Is Speculation, and How Is It Different From Investing?

In a 1964 court opinion regarding obscenity in motion pictures, U.S. Supreme Court Justice Potter Stewart famously said, “I know it when I see it.” The line between the acceptable and the obscene is highly subjective and lacks clearly defined parameters, so Potter did his best to thread the needle. (For what it’s worth, Potter argued content in the movie “The Lovers” was not obscene and was constitutionally protected speech.)

Now, to the question at hand. What is speculation, and how is it different than investing? We’ll need to borrow from Potter’s playbook, as there’s no clearly defined line between speculation and investing. It really boils down to the amount of risk involved in the investment and each investor's broader goals. Generally, speculation and risk are positively correlated: more risk = more speculation. But “risk” is different for every person; and it depends on the asset in question, a person’s holding period, the amount of research they’ve conducted and a host of other factors.

HOW RISKY IS THE ASSET?

With anything you buy, there is a risk of losing your money and the potential for future gain. Some assets are nearly risk free, such as a certificate of deposit from a bank. Outside of a complete, systemic failure of the financial system, you can rest assured your money is safe with a CD and you’ll collect your monthly interest payments. But with a CD, your reward is limited compared to other potential investments. There’s not much that could go wrong, which is why you don’t earn much of a return on a CD.

On the other hand, stock in a company that could be the next big thing (but has yet to make any money), cryptocurrencies or advanced trading techniques — like shorting a stock using options, for example — could be a big payday in a short period of time. However, they can also expose you to significant losses. They’re high risk. There’s a lot that could go wrong — both known and unknown.

An asset’s riskiness is also correlated with the amount of information available to market participants. A home is valued based on comparable sales, scarcity of land, location and a host of other factors. Stocks and bonds can be valued through several methods, such as discounted cash flow analysis, valuing underlying assets, the dividend discount model or relative valuation based on historical correlations with other assets to name a few. In a nutshell, there’s enough information and data to roughly measure risk and the potential for reward.

In general, scant information or a price not supported by traditional valuation methods is the hallmark of speculative assets, which makes it nearly impossible for investors to arrive at a “fair” value or forecast the asset’s potential. Stock in a company that hasn’t made a sale, risky debt issuances in unstable foreign markets and cryptocurrencies all tend to have one or more of these things in common: There’s not much data to work with because regulatory oversight may be lacking, the asset hasn’t existed long enough, or the truth may even be obscured for nefarious purposes or a host of other reasons.

HOW DOES RISK-TAKING FIT INTO THE BIGGER PICTURE?

Every asset you can buy falls somewhere on the spectrum of risk and reward. But how does purchasing it fit into your broader financial goals? Investors tend to balance risk and reward in order to grow their wealth over time to reach certain goals; speculators tend to focus on the potential for a short-term gain without as much concern about the risks they take or how those risks fit into the broader picture.

Investors aim to minimize risk and avoid “the big mistake” by assessing an asset’s historical performance data or applying mathematical techniques to elucidate a fair price, or margin of risk, for an asset. Every technique, of course, relies on certain assumptions (or speculation) about risk and desired returns, but the idea is to balance overall risk.

Speculators may overlook some of the traditional methods of valuation (in many cases it isn’t even possible), perhaps even relying on the idea that someone will be willing to pay more for an investment in the future solely because it is popular. But taking extreme risk is the entire point of speculation. In fact, speculators may even look to maximize risk for a shot at quick profits.

INVESTING VS. SPECULATION

Investors take a holistic view when putting their money to work, which doesn’t mean avoiding risks altogether. However, investors aim to quantify risks, account for them in a plan and strike a strategic balance to build wealth over time. Asset purchases are part of a comprehensive financial plan or strategy. Because investors are in it for the long haul, their financial plan accounts for market downturns with broad diversification and may also include some assets not directly correlated to the market, for example.

On the contrary, speculators tend to take bigger “bets,” allowing something other than time-tested investing principles to guide their financial decisions. The goal is a big gain — of course, with a corresponding big risk. That applies to an individual asset, but it also applies to a person's broader financial picture. Speculators may allocate an outsize amount of their net worth to an individual asset in lieu of broader diversification or building a safety net for a downfall. While the rewards could be mighty, the risks could be equally disastrous to a person’s long-term financial health.

Ultimately, everyone who buys an asset with the aim of generating growth over time is speculating to some degree about the future. But it’s important investors understand where they are on that risk spectrum. There’s a lot of space between speculation and investing, but like Justice Potter, hopefully you will now know it when you see it.

Past performance is no guarantee of future performance. All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against a loss.