As a starting investor it’s important to know the difference between investing and speculating. Many people that don’t know the difference might start their investment career by speculating on the market. These people quickly lose a lot of money because of it, which instantly ruins any incentive to continue. The problem in my opinion is with today’s market, which encourages speculation to an unhealthy degree. Speculation is the wrong way to start an investment career, unless you are fully aware that you are speculating instead of investing.
The meaning of both words is as follows (as found on: Dictionary.com)
- To invest: to put (money) to use, by purchase or expenditure, in something offering potential profitable returns, as interest, income, or appreciation in value.
- To speculate: to engage in any business transaction involving considerable risk or the chance of large gains, especially to buy and sell commodities, stocks, etc., in the expectation of a quick or very large profit.
When investing, money is spent on something that offers potential profitable returns. An investor logically assesses what makes it profitable in the long term and why it would be wise to put hard-earned money into it. When speculating, risks are taken with transactions in expectation of a quick or large profit. The transaction is often a gamble on two conflicting outcomes. Either the speculator wins or loses.
Of course there are people who made money with speculative transactions on the stock market. The problem is that it’s highly unlikely to continue a winning streak. Let’s say that with each transaction a speculator has a chance of 50% to make a profit. If a speculator decides to make only one transaction, he would have a 50% chance to make a profit with that single transaction. But the speculator likes the taste of profit and decides to make two transactions. The chance for him to win both transactions is now reduced to 25% (50% of 50%). With five transactions, there will only be a 3,125% chance of gaining profit with all transactions. If the speculator keeps this up, losing money eventually becomes inevitable.
The risk of losing money is equally great as the chance of gaining money with the above example. So if you just keep the transactions up, earning money will also become inevitable. Of course that’s true, but there is the added problem that it’s very difficult to get losses back. Let’s say our speculator with an initial €10,000 gets a gamble wrong and loses 10% of his money. Instead of €10,000 our speculator now has €9,000. If our speculator decides to continue speculating and gets a 10% win with his following transaction, his funds will not be back to €10,000. It will be €9,900 instead (10% of 9,000). He would need an 11,1% profit to get his initial €10,000 back. This effect becomes even greater with multiple losses in a row. If this speculator loses half his fortune, he will need a 100% win to get his initial amount back.
There is only one party that will get rich from speculation and those are the brokers. Each transaction is paid with a transaction fee that is going straight to the broker. Brokers are companies that need to make money and the more transactions on the market, the better. Don’t fall for this trap when you start investing. Also be careful for those ‘investment’ apps that are roaming the iOS and Android markets these days. Most of these apps let you ‘invest’ money by deciding if an index or stock will rise or fall. It is nothing more than gambling and any self-respecting investor should steer far away from these apps.
Figure 1: Beware trading apps like Bux. Bux is a fun little app, but it’s pure gambling with high risk contracts for difference (CFDs). They advertise it as though you are playing with ‘the big boys.’ You’re not.
If you decide to speculate than be very aware you are gambling with your money. There is nothing wrong with being a speculator as long as people know that it has nothing to do with investing. Making a quick buck is very tempting, but like everything else in life: nothing comes easy. The longer one speculates, the higher the chances of eventually losing money.