Are you investing or speculating?

Are you investing or speculating?

By Olawale Hamed 

In finance, an investment is defined as monetary assets purchased with the idea that the asset will provide income in the future or appreciate and be sold at a higher price.

Speculation is the act of trading in an asset, or conducting a financial transaction with a significant risk of loss of part or all of the initial outlay, in expectation of a substantial gain.

With speculation, the risk of loss is more than offset by the possibility of a huge gain; otherwise, there would be very little motivation to speculate. Although often confused with gambling, the key difference is that speculation involves deep analysis and taking a calculated risk, whereas gambling depends on totally random outcomes or chance.

There are a number of factors that can be considered in making this distinction and they are highlighted as follows:

Risk appetite:

Risk appetite is different for individuals and firms.  It is the capacity for loss which can be a function of capital available, profit target and personal attitude to risk and uncertainty. A firm with large capital and a large profit target would have a high risk appetite and thus seek long term volatile investment opportunities. On the other hand, an individual with small capital and a relatively small profit target will tend to have low risk appetite and would adopt a short term investment strategy or chose to speculate.

Nature of the asset:

liquid assets like landed property and vehicles are not ideal for speculation but good for investment as they are can generate positive future cash-flows. Liquid assets like Treasury bills, sovereign and municipal bonds, currencies, equity stock and commodities are good for investment but also ideal for speculation. 

 

The amount of leverage

Leverage is the amount of debt used to finance an asset purchase. Investors with low risk appetite often prefer to invest equity or own funds and generally avoid debt, while Investors with high risk appetite and relatively high level of financial acumen will seek to  use debt to finance speculation  with the expectation to cash in on larger gains should their view come out accurate.

Market segment

The financial industry is divided into the primary and secondary market. The primary market is where new securities or assets are sold to investors or speculators alike. The secondary market is available for trading existing securities or assets largely for speculative purposes. It also provides a platform for investors that missed the primary market opportunity to invest. These investors can purchase investments at slightly higher prices from speculators who acquired these assets from the primary market mainly for speculative purposes.

Arbitrage

Arbitrage is taking advantage of price differences in two markets to make a profit. For an investor, arbitrage opportunities may exist at some point in the duration of the holding period, which usually allows the investor cash in by selling his investment earlier than planned. A speculator rarely buys assets to hold as his aim from the beginning is to seek arbitrage opportunities, which are sometimes instantaneous or available within minutes of trading.

Investing usually involves the creation of wealth, whereas speculating is a zero-sum game as near term temporary positive cash flows may exist although ultimate wealth creation is not often the end-result. Although speculators make informed decisions, speculation cannot usually be categorized as traditional investing.