Most of us have had this colleague at least once or twice. The one that comes into work with a spring in their step (I can sense that you’re tensing up already) and over your coffee break chit chat regales you with how they’ve bought some shares or a piece of land.
The conversation usually goes something like,
‘Hey colleague, I’ve made this great decision in my life of buying this asset. I’d like to inform you that it’s been one of my best decisions, the value of it has already risen by $x! I knew it would do this because of various factors I’d taken into consideration before buying’
The inference being that they have some inside knowledge that others don’t or they really just want you to know that they’re a bit better off from last week than you are, without all that gosh darned work everyone else is putting in.
I can tell you this story in this way because I was this person for a few months and I’ve heard it from others a couple of times too.
I was 21 and was working in what essentially amounted to an insurance sales boiler room. Our customers bought reasonable insurances like car or home insurance, and we’d then thank them for their business by harassing them with multiple phone calls to buy worthless insurances that never paid out, with very high premiums compared to most and being encouraged to guilt them by asking ‘Do you have a plan for your family if ‘x’ happened to you or them?’. Not a nice job.
I decided I’d start using Plus500 on the side, an online share buying platform that uses leverage. This was my way to get into learning about shares with an eye to day trading. This was around 2011/2012 at the start of the Greek Debt Crisis.
Because I was clever and I’d watched the news, or so I told my colleagues, I’d mainly gone short on Greek shares (sold the shares before buying them, essentially I’d make money if they went down in value). I’d put in 500 of the Queen’s finest pounds and grown it to over £1000 within a few weeks. I justified this with a few of my own political biases and historical takes on the situation. I’m sure they hated me, I would have.
I continued to hold onto these shorted Greek shares and they continued to fluctuate. The news was telling the world that Greece will default at any moment and everything within it’s borders will be worthless.
Now you’re probably thinking that I’m going to tell you that it all turned to custard and I lost it all. Well, no. I cashed out at £750 – £250 profit in all.
So why would I tell you this? Well, the truth in this isn’t whether a profit or loss was made but what was learned.
The key point was that the news, and therefore my reality as far as Greece was concerned, had very little correlation to what the share price was now doing. The shares were rising in value, the opposite of my prediction, wiping out some of the gains I had made in that time. I’m sure someone can fill me in on why that happened but even then, it’s 20/20 hindsight at best.
Why didn’t I cash out at £1000? If I crystallised my gains by selling, what could I invest in next? How could I possibly know if I was buying in a peak or a trough and how quickly that might change?
The answer to all these was that I didn’t know, and if I did, I wouldn’t be working in a poxy call centre.
The only thing I learned about day trading was that I had absolutely no control over the result. Perhaps other more knowledgeable people do but little Andy here, whose credentials didn’t extend much further than filling in a Plus500 sign up form and debit card details certainly didn’t. Realistically, in this manner, what was the difference between picking a share and picking a horse? I decided to quit at £750 before one of my colleagues asked me how things were going and I’d no doubt have to sheepishly tell them I’d made a loss. This way I made a profit and didn’t lose face.
I’m certainly not saying don’t buy shares and I’m not saying don’t buy land (I might say don’t buy horses!), what I will suggest is don’t buy them like this, where you essentially guess off a hunch and make up your reasons to justify your decision after the fact.
Whilst I thought I was investing, simply because I was putting money into an asset with the intent of making a profit, I was really speculating. These terms are used relatively interchangeably colloquially but there are definite differences.
Which brings me to the overarching point.
What’s the difference between a speculation and investment? In terms of how we can separate the two in a practical sense, it’s about where you intend to draw the projected income from.
Investment – Your profit is primarily drawn from the income the asset produces. This can be in the form of rent or dividends.
Example: You buy a share in Acme Company for $100. It pays a 10% dividend which is the best return on your dollar you feel you can achieve.
Speculation – Your profit is primarily drawn from the increase in the asset’s value.
Example: Based on your astute observations, Silver is at a bargain price and you feel it’s got to go up in value. You buy at $100/oz and plan to sell once it hits $120/oz
It’s not to say that any single type of purchase, whether it be shares or property, is either a speculation or an investment exclusively. The same category of purchase can be either.
A house is bought for $500k. The purchaser buys as they expect local house prices will rise due to new transport links with the city centre, the intention is to sell once it hits $750k in value. The rent collected is secondary. This is speculation.
Another house is bought by a different purchaser. It provides an 8% return in rent, whilst the holding costs only run at 5%. The purchaser buys as they want to to use the 3% difference to supplement their regular income. The potential rise in capital value is secondary. This is investment.
Both have bought a house. Both have bought with the intention of drawing a profit but the methods of drawing that profit are entirely different.
That’s also not to say that investments can’t rise in value and be sold off at large capital gain. They can and do, but it wasn’t the primary intention of the buyer.
With speculative instruments, when you sell, you realise the loss or gain. This is your profit and you must continue to speculate with new purchases to continue to draw an income in this manner.
The risk is higher with speculation as you’re drawing your profit from an unknown variable, namely which way the price will go and by how much. If people knew where the price was going, it would already be at that price. The rewards can be massive but equally the losses can be devastating.
Even the best of us can only guess the outcome correctly a small percentage of the time which is why investments make more sense for the early retiree as the bulk of their retirement plan. Sure, you’re less likely to have that one off win where you make bank for life with little to no effort, but you’re also less likely to lose or go bankrupt if your investments are wisely chosen.
With investments, the owner draws an income from the asset for as long as they own the asset. The owner knows approximately what the income will be from the asset from day one. Investments are therefore more ideal for a steady income and an early retirement.
The risk is mitigated with an investment because if the price does drop, the owner can continue to hold on and ride out a market downturn without any cost to holding the asset as the income will likely continue to cover holding costs.
Neither investments nor speculations are inherently good or bad, and the advice here is neither prescriptive nor proscriptive. Both are necessary functions of markets and hey, a little speculation here and there can be fun, but being able to distinguish and understand the risks is really important to your early retirement and financial security.
The advice is to not bet the farm on speculation and choose strong, steady investments for the bulk of your portfolio.