Q&A: What is the difference between investing and speculation?

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What makes ‘investing’ different from ‘speculating’? Is it just the amount of risk, or are there other differences? How can I know if what I think is an investment decision is actually speculating?

Investing, as I would define it, is something that has a real intellectual underpinning where it's evident that you're making decisions based on facts and data. In other words, you have good reason to believe you’re paying a good price for an asset relative to its real value, so you’ll almost certainly see appreciation, especially over a long period of time.

“Investing is something that has a real intellectual underpinning, based on facts and evidence. “Speculation is trying to turn a quick dollar in a short time-frame without much margin of safety.”

So, investors put in the time and work to do their due diligence. Then, we make a small number of careful, thoughtful decisions a year. It's not something that you can do just because you're bored, like day trading.

By contrast, when you get into speculation, it's because you think you can turn a quick dollar in the immediate or short-term future. It’s guessing, maybe educated guessing, but it doesn’t offer the same margin of safety to protect against the risks of the transaction turning against you. It just involves too few facts and too many assumptions.

The short timeframe is a big part of it. Day trading, one form of speculative investing, doesn’t let the inherent process of appreciation happen. It doesn’t have the patience for that. You’re hoping for or assuming there will be a sudden shift in some factor that will change the value in a temporary way. This approach only works reliably well in a momentum environment. Even then, a lot of it is driven by people chasing trends or advice they just heard online.

In some ways, it comes down to reasoning and what you’re focusing on. Consider making a real estate investment. If you’re investing in a cycle that is very favorable, and you just want to own the property for a little bit and then hope to sell to someone else in three to six months, that strikes me as a very speculative position. You’re assuming (guessing) that a lot of factors will continue in your favor, like ongoing liquidity and a continuation of the current level of optimism or interest in the market/property.

Say you're buying a million-dollar building that's overvalued, and you're getting $10,000 in rents. Then, that asset loses 15% of its value ($150,000 on the original purchase). There's no amount of rent that will overcome the fact that you paid a bad price. You were speculating that, somehow, people there would continue to be willing to overpay.

Indeed, in 2000 Warren Buffett wrote in a classic Berkshire-Hathaway letter that in speculation “the focus is not on what an asset will produce but rather on what the next fellow will pay for it.”

So, to do these speculative transactions, you also need to speculate that everyone in the system is going to cooperate, from underwriters to lenders to buyers, that the “next fellow” will pay what you want or expect. But it just doesn't really work that way.

True investing reverses this. It focuses on the value an asset will produce. If the investor can link a real estate purchase to underlying cash flows, or they demonstrate that the valuation is depressed based on historical averages (and thus is underpriced relative to actual value), that's more what I would consider a solid investing framework.

This is not to say speculation should be avoided by everyone all the time at all costs. But neither should it be confused with true investing, and no one should bet the bank on speculative deals.