Why Speculation is Not a Good Idea?

When we think of making money in different markets by deploying the cash we already have, predominantly, there are two styles or approaches that come to our mind. One is either to start a new business or buy ownership in a running business and be a partner in the profit and loss that the business is going to make during its operation. The other is to time your entry into and exit from the markets in a way that the difference of the buying and selling prices is your profit or loss. The former is an investment while the latter can be termed as speculation.

The purpose of writing this blog post is to carry out a broad comparison of these two styles of committing our money and see why investment is safer, surefooted, and preferable for an individual investor, and speculation, though quite exciting, is not a good idea, in the ultimate analysis.

Definitions

Before proceeding further, let’s first define these two terms.

Investment

Three cornerstones of any investment operation are thorough research, safety of the principal, and an adequate return. The aim of the investor is to, first, ensure capital preservation and then create wealth. He understands very well that it is going to take time. He also realizes that, in order to be successful, he has to carry out a detailed research and has to analyze all dimensions of the investment proposition, including the risk involved. His main purpose is to beat inflation, and over and above that, earn a few percentage points per annum. He likes to make realistic and safe assumptions. He understands financial risk very well and prefers to assume the essential risk only. For reading more on risk, please click here.

Speculation

On the contrary, speculation is an activity that is aimed at capturing quick profits. Undeniably, such opportunities are either available or can be created in the markets, especially in the secondary markets. Actually, the way secondary markets are designed, some degree of volatility or price fluctuation is inevitable. In speculation, the entire business model hinges on one factor i.e. when to get into the market and when to get out. It has nothing to do with how the business itself is performing. Market volatility is the entire business model.

To read a detailed comparison of investment and speculation, please click here.

Why Speculation is not a Good Idea?

I will, now, discuss various reasons why, I think, speculation is not a good idea and why an investor should refrain from it.

Speculation is essentially a short-cut and obviously it doesn’t always lead to the destination.
In speculation, there is a higher probability of permanent loss of capital, particularly when the asset in question doesn’t have an intrinsic value. For an investor, however, capital preservation is the first priority.
Speculation is similar to gambling whereas investing is like owning or running a business. It is, therefore, said that anyone who speculates will ultimately lose his money.
Investment is similar to eating for health and speculation is similar to eating for taste. The eventual outcome in both the cases is obvious.
Speculation is a uni-dimentional activity. It only takes the price into consideration and completely disregards what the business is earning every quarter. So, if the price doesn’t appreciate according to the expectation, the trade will result in a loss.
It is very exciting and that is its main attraction. When someone is able to close a trade successfully, he mistakenly starts believing that it can always be done. It encourages him to play a bigger hand next time. If he wins a second time, he is emboldened further and starts allocating more and more capital to such undertakings. His greed is at its peak and he forgets everything about risk analysis and mitigation. He doesn’t realize that he is entering into a bubble that can burst anytime. Inevitably, it happens, washing away all his gains, including those of his previous trades as well.
Speculation solely focuses on market analysis for decision making and completely disregards business analysis. The market is so complex that it is un-analyzable and its direction cannot be determined, especially in the short-term. Therefore, the decision to buy more or sell your holdings at a particular price is a “toss of coin” like thing without having any rational basis.
After a strenuous effort and taking all kinds of unavoidable risks, if a business earns 15-20% ROI per annum, the owner feels happy and satisfied. An investor also expects the same. Whereas a speculator wants to make much more than that effortlessly. To what extent it is a realistic expectation is anybody’s guess. He doesn’t want to answer the following question. If speculation is such a good strategy of earning a lot of money quickly, why a businessman, who has much more knowledge about the business and markets than a casual speculator, doesn’t liquidate his business and starts using his capital to earn quick and effortless money through speculation?
A speculator makes an error of judgement thinking that he will always be able to get in to the market and get out of it at the most appropriate time. What he doesn’t realize, however, is that when speculation is rife, almost every other person in the market is thinking the same way. Who will be able to get out in time and who will be left behind to foot the bill is a very difficult question which we should not even attempt to answer.
A speculator can never know how to respond to falling prices in the market. Whether to sell his holdings and cut his losses or to buy more at low price to improve his buying average. He is always in two minds. For an investor, though, the choice is pretty straightforward. He carries out a lot of research and due diligence before buying something and his plan is to never sell it. When the price of the same asset falls, due to any reason, since he has no doubt about the quality of the asset, he buys more of it at discount. Earnings from the same asset or dividends can be used to buy more. In short, while investing, drop in price creates more buying opportunity, whereas in speculation, it is confusing.
In investment, earnings of the business is an important variable, which either doesn’t exist or not heeded to, in case of speculation. Price determination becomes difficult in case of speculation and what should be the right price to pay for an asset is always a challenge. An investor, on the other hand, can have a fair idea about how much an asset should be worth by relating its asking price with its current and future expected earnings.
Speculation is fuelled by news and rumors instead of research and analysis, hence the results are erratic and choppy, not suitable for an individual investor.
Whenever you commit your money somewhere with the purpose to take out more money subsequently, as you do in investing or speculation, you have to have a system of predicting the future. Now compare the market, in general, and a specific business, in particular. Which one is easier or safer to predict. Obviously, it is the individual business. Market is a very complex phenomenon and doesn’t lend itself easily to forecasting. I am reminded of a very interesting quote form Mark Twain which reads, “Predicting is difficult, especially when it is about future”.
From the market perspective, speculation has only one positive aspect and that is, it provides liquidity to the market. Whereas investment is overall a very positive activity. It promotes enterpreneurship, encourages business development by providing required capital and creates a win-win deal for all stakeholders.
While investement creates new money which is equitably distributed among the stakeholders, in speculation, money changes hands only. Therefore, some get more that their due and others are deprived of their hard earned money. Who gets what is decided on the basis of luck or information asymmetry.
Speculation disturbs the balance of the supply of money to various sectors of the economy. It creates bubbles in some areas whereas the other sectors become cash-starved. This is not good for the overall health of the economy. At some stage or the other, the market participants or the individual investors also get affected by these bubbles and can lose their life savings. The best strategy is to stay away from these bubbles.
Before concluding, let me give few interesting quotes on speculation here:
- In pratical life, the wisest and soundest people avoid speculation. (George Earle Buckle)
- Speculation is a parasite, feeding upon values, creating none. (Andrew Carnegie)
- The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. (Benjamin Graham)
- There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can. (Mark Twain)
- October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February! (Mark Twain)

Conclusion

Speculation is an unhealthy and dangerous activity to undertake with your hard-earned money. It is quite exciting and thrilling, as opposed to investment, but the ultimate result can be quite unwelcome. A preferable way should, therefore, be to slow down and be deliberate. Keep capital preservation your first priority, beating inflation your second, and a reasonable profit your third. Hopefully, you are going to end up very well.

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My other articles you may find useful are:

How to Make a Personal Financial Plan – Basic Considerations

Personal Finance – A Suggested Checklist

Investment vs Speculation

A Brief History of Money

Why I Started a Blog on Personal Finance

Anatomy of Financial Risk

Debt, Equity, and Real Estate: An Overview

Retirement Planning

How to Compare Equity and Real Estate as Investment Options

How Stock Market Works and How to Work in Stock Market?