The Difference Between Investing And Speculating

by: David Fabian

Summary

Investing isn’t always easy, and 2016 has certainly proven that volatility in the stock market can lead to significant shifts in investor sentiment and philosophy.

Investing is when you create a rational plan to grow your earned capital through a systemic process of investment in multiple securities or asset classes.

Speculation, on the other hand, is when you take out a lottery ticket.

Investing isn't always easy, and 2016 has certainly proven that volatility in the stock market can lead to significant shifts in investor sentiment and philosophy. A correction of this nature should be viewed as an opportunity to analyze your current strategy to ensure it is measuring up to your expectations. What it should not do is cause you to deviate from a sound philosophy of investing to a gambler's streak of speculation.

Let me explain what I mean.

Investing is when you create a rational plan to grow your earned capital through a systemic process of investment in multiple securities or asset classes. It may include converting your cash to stocks, bonds, commodities, mutual funds, or ETFs in a manner that conveys a disciplined approach to risk management alongside a defined process and time horizon.

For most investors, this simply means building a balanced portfolio that takes into account their specific risk tolerance, experience, and goals. That plan will then be subtly adjusted over time as your life changes, you accumulate or redeem capital, or your philosophy takes on a different form. The themes change, yet overall, the basic building blocks of investment in the stock and bond markets have been similar for generations.

Speculation, on the other hand, is a completely different mindset that is more akin to gambling than true investing. You don't wake up one day and put $5,000 in the Direxion Daily Gold Miners Bull 3x ETF (NYSEARCA:NUGT) as a long-term investment opportunity — you do it because you think you can make a killing in a short period of time.

This chart should illustrate that point distinctly:

Click to enlarge

Sometimes that opportunity pays off through timing, and maybe a bit of skill in reading the fundamental or technical tea leaves. Other times, you get scorched, and end up selling at a loss, with a big helping of regret and earnest promises to never to do it again.

The former is honestly far more damaging than the latter. Bear markets bring about a sense of frustration with the fact that the "normal" system you have relied on for years is not working. But you keep hearing about those guys trading gold stocks, volatility futures, Treasury contracts, leveraged ETFs, bear funds, and options bets that are making a killing.

Naturally, you ask yourself, why can't I do that too? I can own all those types of investments through an ETF in most of my retirement or brokerage accounts.

So you buy a little NUGT or ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY), and BOOM! in a matter of a few days, it jumps 15%. You sell, bank the profits, and all is right with the world.

Suddenly this speculating stuff doesn't seem so hard. In fact, you can probably fire your advisor or redeem your basket of diversified stocks and bonds. Timing the market is easy when you only have to hold for a couple of days and can magnify your returns! No more riding through those pesky bear markets or fretting over rising interest rates. It's a whole new world.

Of course, that last paragraph is totally sarcasm in contrast to my true beliefs. Speculating in high-risk investments is one of the last things you should be doing as volatility expands. Even though you may hit a few singles with some well-timed trades, the same correlations and patterns you are using to time the market may look completely different a few weeks from now. To state the obvious, it's just as easy to experience a double-digit percentage drop in leveraged or inverse funds, as it is to make that much on the upside.

This same mantra holds up for individual stocks too. There is a big difference between buying Yahoo! Inc. (NASDAQ:YHOO) because it has fallen 50% and you are hoping for a face-ripping bounce or buyout offer rather than because you love the platform and think it's a solid company to own long term. Make sure you consider your motives before putting money to work, as unintended price action can have deleterious effects on your decision-making process once you are committed.

I think it's also worth noting that trading does not automatically equate to speculating. There are some very methodical traders with short-term time horizons and a risk-aware approach that are candidly investing in a more active manner. The difference is that they have time, tools, and discipline that have been honed by experience, and the most successful stay within their refined process.

Remember that volatility is not a transient event. It is something that is constantly with us and causes the market to move both up and down in unpredictable ways. If you have found yourself straying from a sensible portfolio strategy, take the time to evaluate your decisions to determine if you are making changes for the better or possibly worse. Sometimes that simple exercise is all you need to snap back to reality and re-focus on a plan that makes sense to reach your goals.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.