There is a profound difference between investing your money and speculating with it. The former suggests that you have a sound methodology in place from which you can draw conclusions and gain valuable insight for your investment decision making. A sound investing philosophy lends credibility to one's actions, and increases the odds of success.
The latter, on the other hand, suggests that you have no investment philosophy to fall back on. As a result, you are merely speculating, and are quite comparable to people carrying their dollars into a casino to play roulette.
You are essentially betting on good luck and hoping that the momentum in a stock, or a market, continues for a little while, so that you can cash out when the time comes. In other words, investing relies on reason, methodology, and calculation, while speculating relies on odds and momentum.
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Speculation leads to stock market bubbles
People are easily seduced to speculate with their money for a variety of reasons:
- Speculating, say, on an increasing stock price doesn't require any significant amount of hard research, and is therefore enticing.
- It appeals to our human condition, which seduces us to take actions to get rewarded instantly and to get rich quickly.
- Other people do it, so why don't we just join the group?
The problem with that kind of thinking is that stock market bubbles always happen because of a speculative mania. It works something like this: Many people buy the same stock at the same time, while valuation concerns are pushed aside.
At some point, profit taking and the lack of new buyers cause the stock to drop, and everybody rushes out the door at the same time. This is a repeating pattern in the stock market, and a determining characteristic of asset price bubbles.
Hefty price movements and collective speculation have a magnetic influence on most people. They can't resist the urge to be part of the group that appears to make money so easily and effortlessly.
And that's exactly the problem with speculation: It is based on emotions, not on reason or logic. Think about this analogy for a moment so that this point about financial decision making sinks in: Would you consider selling your home in an instant just because your neighbor shouted a low price for your house over the fence every once in a while? Hardly.
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The dangers of speculation
Speculation is mainly driven by a person's desire to get rich quickly. On the other hand, what is wrong with getting rich slowly, just like Warren Buffett asserted at some point in his investing career?
If you speculate, make sure you only do so with money you don't need later on, and don't speculate with money you earmarked for a house down payment or something similar. This is a recipe for disaster. Also, be prepared to lose all your money when you speculate, and understand that your emotions are rarely a good investment adviser.
Investing as a valid alternative to speculation
Consider Warren Buffett, for instance, who has invested his own money and that of his clients very successfully since the 1960s. From 1964 to 2013, the intrinsic value of Berkshire Hathaway, Buffett's investment vehicle, measured by Berkshire's book value per share, has skyrocketed a fantastic 693,518% in total, or 19.7% annually. Not too bad an annualized return, is it?
Buffett's investing strategy has an advantage in addition to delivering above-market investment returns (the S&P 500 returned 9.8% annually during the same time period with dividends reinvested): It leads to significantly lower levels of anxiety and stress.
Speculating keeps you on edge, forcing you to constantly monitor your positions and to keeping an eye on stock quotes, never really being able to let go. Investing, on the other hand, is significantly more relaxing, leaving you with a peace of mind that many speculators can only dream of.
The Foolish bottom line
Stock market history is ripe with examples of burst bubbles that had dire financial consequences for people who chose to speculate on hopes of ever-increasing stock prices and quick riches. But how many speculators do you know who actually beat Buffett's return over longer time periods? Not that many.
Investing is fundamentally different from speculating. Doing your own research and valuation work, relying on critical thinking, and questioning conventional wisdom is what worked outrageously well for Warren Buffett -- and it can work for you, too.
