There has been a lot of chatter in the news lately about fast-growing companies that seem like a smart “bet,” think GameStop, Bitcoin, and overvalued IPOs. The scary part is that many investors are making changes to their portfolios based on advice from crowd-sourced outlets like Reddit. This is NUTS to me! This is the same as being at a cocktail party and having the husband of a colleague tell you that he heard alternative fuel cells powered by Martian dust are gonna take off, and so you should purchase options on them … you wouldn’t do that, would you? So why buy stocks based on what Facebook and Reddit tell you.
That is why this month’s Edu-Blog series will focus on investment versus speculation. There is a difference, you should know what it is, and you should really have a solid idea of what your risk tolerance is before you make any decisions, whether it be investing, speculating, or any other money-related activity.
Two things I’ve learned in my years in the business are that you need to understand the difference between investing and speculating, and you need to know your risk tolerance.
These are the two main points investors need to consider when making wise decisions with their money.
1. Know the Difference: Investing vs. Speculating
People define investing and speculating differently. Basically, an investment is an asset that you own whose purpose is to generate income by appreciating in value.
On the other hand, speculation is the purchase of an asset with a substantial risk of losing value AND the expectation of significant gain using leverage or foreign currencies.
Now, we all know that risk is a part of investing, but the main difference in the definition of investing vs. speculating is the world risk. Risk is increased with speculation in that losing your entire investment, including the principal or the original amount you invested, is a greater possibility than when simply investing.
Risk isn’t the only factor to consider when investing. Things like time horizon, i.e., the amount of time between when you invest the money and when you need it and even your attitude toward the decision, are critical.
Now that you know the difference between investing and speculating, it’s time to look at what would be considered an investment versus a speculation. Investments are things like stocks, bonds, treasuries, mutual funds, vehicles that are probably, at the very least, familiar to you. On the other hand, speculative assets are things like options, futures, foreign currencies, start-up companies, and cryptocurrencies. The below chart does an excellent job of simplifying and breaking down the differences between investments and speculations.
2. Determine Risk Tolerance and Investment Objectives
Risk tolerance is critical; it is most likely the bottom line or determining factor for every investment decision we make. Take, for example, the portfolio of a 35-year old male head of household and a 65-year old male head of household. Their portfolios should look vastly different because of their risk tolerance. The 35-year old can tolerate far more risk than the 65-year old for the simple fact that he is farther away from retirement.
Understandably, the 65-year old will have a more conservative portfolio with a higher allocation to bonds because the main objective of this demographic is saving for retirement. Often, municipal bonds are used to create tax-free income for older investors. On the other hand, a younger investor will have a much different portfolio. Since a young investor has more earning years before retirement than an older investor, they can take more risks because they conceivably have more time to recover from losses.
There is a place for speculative investments in certain portfolios. Your risk tolerance and goals must be considered to know whether your portfolio will benefit from an allocation to more speculative investments. Investors that are comfortable tolerating volatility over the long-term can think about adding speculative investment vehicles to their portfolios. However, if you are older and near or in retirement, these are investments to avoid, like the plague. The gamble between increased risk and increased return with speculative investments is not worth it when you are older.
Stay tuned for Part 2!
P.S. If you enjoyed what you've read here and found it beneficial, we encourage you to share it with your friends and family. I firmly believe that an educated investor is a healthier and more confident investor.
Until next time...
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes.
Investing involves risks including possible loss of principal. No strategy assures success or protects against loss. All performance referenced is historical and is no guarantee of future results. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market. Bonds are subject to market and interest rate risk if sold prior to maturity.