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Speculating vs investing

Lesson in Course: Investing basics (beginner, 4min )

Speculating is often confused with investing. How can tulips and GameStop teach us the difference?

Eureka!
  • What it's about: Speculating focuses on very short-term price movements, whereas investing is based on a longer-term view on the fundamental value of what we're buying.
  • Why it's important: Speculating isn't inherently bad, but it's inherently very risky.
  • Key takeaway: We can avoid losing a lot of money by recognizing when we're speculating and by speculating responsibly.

Imagine paying somewhere between $50,000 and $150,000 for a tulip bulb, with the best bulbs fetching $750,000. During the 1630s, the Dutch were obsessed tulips imported from Turkey. They were a status symbol of luxury and affluence.

The price of tulips soared from the rising demand to have gardens filled with them. Folks started buying bulbs simply to sell them at a higher price for a profit, and some even began borrowing money to buy more!

Eventually, the tulip bubble popped, and prices collapsed, causing a lot of people to lose everything. We can get rich quickly by speculating, but it can leave us broke just as fast.

What is speculating?

Speculating

Speculating is simply buying something with the hope the price will go up in the very near future.

At first glance, this doesn't seem too far off from investing because the intentions are the same (buy low, sell high); however, the big difference is how speculators and investors decide what to buy.

The difference

When we speculate, we make decisions based on what is happening to the price of an investment in the short term with the hopes of making a quick buck. As we saw with tulipmania, folks stopped buying tulip bulbs to put in their gardens and started buying them because the price was rising.

On the other hand, when we invest, we base our decisions on the fundamental value of what we're buying. If we invest in the stock of a company, for example, we care about the company's performance rather than simply looking at how the stock price has moved in the near term.

 

Who are speculators

Speculators tend to be active market traders trying to make money on short-term price changes. 

  • Bullish speculators buy something expecting the price to rise
  • Bearish speculators profit when the price falls
  • In general, speculators are willing to take on greater risk than investors.
Day traders

Day traders are short-term speculators who buy and sell an investment, like stock, within the same day so that they don't hold any investments when the market closes. 

Day-trading started professionally as a group of traders who start the day with cash, no investments. Then they buy and sell stocks throughout the day to capture small price movements, buying during the lows and selling during the highs. Their goal is to only hold cash (hopefully more than they started with) by the end of the day.

Mobile trading platforms like Robinhood have since enabled everyday people to try their hand at day trading, even though it's notoriously hard to do.

 

The good

Speculating is often viewed as gambling, but some benefits get overlooked.

  • The active trading that comes with speculating improves liquidity in the markets, making it easier for everyone to buy and sell their shares. 
  • Thanks to their high-risk appetite, speculators also provide money that helps strained businesses grow and struggling governments survive. 

the bad

The dangers of too much speculating are all too familiar. High prices lead to bubbles, like tulipmania, that burst and leave many folks financially ruined. We've experienced this before during the dot-com crash in 2000 and the housing crisis in 2008.

 
GameStop: when an investment becomes speculative

What happened with GameStop and other "meme" stocks at the beginning of 2021 was nothing short of incredible, and it highlights how an investment can quickly become speculative.

GameStop stock short squeeze: Reddit traders take GME on a wild ride I FT  Film - YouTube

GameStop was trading at around $4 per share in March 2020 when an investment thesis was shared on Reddit, stating that the company was undervalued after looking at the company's performance. The shares rose in September on the success of product sales, still grounds for a good investment.

Things changed quickly when the short positions of hedge funds were exposed on Reddit. This was a turning point because many folks started buying GameStop stock to stick it to Wall Street rather than a belief in the company's performance. As the price skyrocketed, topping at $483, more and more investors worldwide were getting in.

Source: Google Finance

The rapid price movements in the stock created a whole group of day-traders who went on /r/WSB (Reddit's WallStreetBets channel) to make a quick buck.

The GameStop bubble wasn't difficult to imagine since many folks on Reddit were sharing their positions, further fueling the speculation. It's hard to blame everyone who participated since speculating can be very exciting, and there's a chance to get rich quickly. However, notice how the price can fall as quickly as it rises.

Speculating relies on guessing how a large group of people will behave. So, it's important to catch ourselves at times when we are feeling FOMO (fear of missing out). In these situations, there are usually more people losing money than the number of folks making money. We don't want to mistake a lucky guess for skill or a good investment.

Actionable ideas

Before making an investment decision, ask yourself, "why do we want to make that decision?" If you realize that you're reacting to a price movement in the market, you could prevent yourself from speculating and making risky decisions. 

Speculating can be done responsibly. A prudent strategy is to set aside a portion of our money to speculate with, but be prepared to lose it all. Then apply sound investing principles to the rest of your money. 

By avoiding large speculative pitfalls, you can manage how much money might be lost from risky decisions.

Supplementary materials

Watch a short clip to review speculation

 

https://www.youtube.com/embed/ilwk1Dm7Yzg?start=67&end=407

Glossary

Speculating / Speculation / Speculative / Speculate

Buying assets entirely based on the hope the price will go up without any firm evidence other than short-term changes in price.

Day traders / Day-trade / Day Trade

Day traders are short-term speculators who buy and sell a stock in a very short amount of time.

Day-trading started professionally as a group of traders who would start the day holding no stocks, and during the period of the day buy and sell a popular stock to capture small price movements. The day-traders would speculate on price movements and try to buy during lows of the day and sell during the highs with the goal to end back in only holding cash at the end of the day. Mobile trading platforms like Robinhood have since enabled everyday people to try their hand at day trading, even though it's notoriously hard to do.

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