Investment Vs. Speculation

Investment Vs. Speculation
••• Jupiterimages/ Images

Everyone who deals with financial markets seems to draw a line between investing and speculating. However, there's surprisingly little agreement about exactly where that line should be drawn. In broad terms, investment involves buying assets based on their perceived quality, while speculation involves buying assets based on where you think their prices are going.

Investment Defined

Imagine a company that takes in a lot of money, makes solid profits and enjoys a strong market position. As it grows, it becomes more valuable. Since shares of stock are just shares of ownership in the company, the stock also increases in value. Meanwhile, the company may be distributing profits to its shareholders as dividends. If you buy shares in the company with the intention of holding onto them for the long term, collecting dividends and watching your shares gain value, that would meet just about everyone's definition of an investment.

Speculation Example

Imagine another company that doesn't earn much revenue doesn't produce big profits. In fact, it actually loses money and doesn't seem to be in a position to turn a profit. However, you just heard on TV that some media personality thinks the company is a hot stock for the coming year. You buy some shares on the expectation that demand will soon soar, which will push up the price and allow you to make a quick profit. By just about every definition, that's speculation. You're really not interested in owning a piece of the company behind the stock, you're betting on the price going up based on market psychology.

Middle Ground

In the real world, investors apply a range of strategies which range from pure investment at one end to pure speculation at the other. Most fall somewhere between the extremes. When they choose which assets to buy -- such as stocks, bonds, commodities or real estate -- their motives may be partially speculative. That's why it's so hard to pick one thing that differentiates real investment from speculation.

Opinions Vary

An influential paper published in the Journal of Portfolio Management examined 20 definitions of market speculation and found they not only varied but often contradicted one another. Some defined speculation as simply seeking to gain from a change in price, while others said speculation necessarily involved higher risk or a shorter time period. The one thing they generally had in common was those who wrote them held investment in higher regard than speculation. People tend to see themselves as investing and others as speculating.

The Graham Definition

Perhaps the most famous definition was offered in 1934 by Benjamin Graham, commonly referred to as the father of value investing. In the textbook "Security Analysis," updated versions of which are still in use in business schools, Graham and co-author David Dodd said an asset purchase is an investment if your goal is to protect the money you invest while getting an adequate return. Anything else, they said, is speculation.