Investing vs Speculating

Foreword

I want to start by noting that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, via some formal classes, but mostly self-taught.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

This post is the first of 3, and is meant to lay the groundwork for the following posts: Investing vs Speculating 2 and Investing vs Speculating 3. A separate related post Zero Sum Game rounds up why understanding investing vs speculating is important.

Definitions

I personally prefer the traditional/classical definition of investing vs speculating, which is roughly:

Investing – The act of putting money to use, by purchasing some productive asset, and then profiting from the products of that asset. For example, by buying a business with a factory, and then producing Widgets (the product) which can then be sold by the business for a profit.

Speculating – The act of buying and selling assets with the intention of profiting from the appreciation in prices of the assets. For example, by buying the same business above, and then selling the business (not Widget!) again to someone else at a higher price.

For some, these definitions may seem foreign — for anyone who started managing money around the late 90’s, their personal definition of “investing” may be closer to my definition of “speculating”, or at least, a mix of both. And they probably define “speculating” as something along the lines of “investing with high risk”.

That’s fine! You are certainly allowed to define words as you see fit, within reason. But I feel that while we are on the topic of finance, we should probably use definitions from finance. This avoids ambiguity, since different people reasonably can have slightly different preferences on definitions.

Hopefully in the following post and future posts, this differentiation and the reason for it, will become clearer.

PredictableCo

Let’s say everyone in the world has a crystal ball, and can see for a company, PredictableCo, how much profits it’ll make before PredictableCo does out of business sometime in the future. How PredictableCo ends doesn’t matter, but let’s just say it goes bankrupt (i.e: stock is worth $0) (1).

Now, the crystal ball is mission specific, and only allows you to see the future profits of PredictableCo, and nothing else.  Specifically, you do not know future interest rates, just current and past interest rates.

So, given this, how much should PredictableCo be worth now?

The answer should be trivial — PredictableCo’s future profits are essentially “risk free” (because crystal balls are like boy scouts — they never lie).  So, take all pending future earnings, discount to present using the relevant “expected future interest rates”, and that’s your price for PredictableCo.

However “expected future interest rates” are, themselves, speculative — nobody knows what they’ll be (crystal balls for future interest rates is a developing feature). Right now, there’s just a bunch of assumptions and predictions for them.  So, if person A assumes future interest rates will be higher, they may be willing to pay less for PredictableCo than person B who assumes future interest rates to be lower.

That said, we can make this statement, which I believe will be true:

The net amount of gains and losses, from all investors of PredictableCo, across all time, based only on PredictableCo, will be exactly equal in dollar value to the sum of all earnings of PredictableCo.

As a simple example, let’s say PredictableCo generates $100 a year for 10 years and then goes bankrupt. The exact way this $100 is returned to the owner is mostly irrelevant for this discussion, but let’s say this is paid out yearly as dividends.
Total earnings = $1,000.

Let’s say I create PredictableCo from nothing in year 1.
Year 1:
I make $100 from the business.

And then I sell PredictableCo to B for $500 in year 2.
Year 2:
I get $500 from B.
B pays $500 to me, makes $100 from the business.
Net for me: (100)+(500) = $600.

In year 4, B sells PredictableCo to C for $200.
Year 3:
B makes $100 from the business.

Year 4:
B gets $200 from C.
C pays $200 to B, makes $100 from the business.
Net for B: (-500+100)+(100)+(200) = -$100

C then holds PredictableCo until year 10 when it ceases to exist.
Years 5-10:
C makes $100 each, total $600 from the business.
Net for C: (-200+100)+600 = $500

Net for everyone = $600(me) – $100(B) + $500(C) = $1,000 = total earnings of PredictableCo

To put it simply, the net amount of absolute dollars that everyone makes from a single company, simply from trading/investing/speculating on that company, is just the sum of all earnings from that company (2).

Investing vs Speculating

And if you think about it, it really doesn’t matter if you know or do not know what the company’s future earnings will be.  The statement still holds.  The only thing that changes, if you cannot predict future earnings, is that the price people are willing to trade that company for is more volatile, because different people naturally have different expectations, same as how they have different expectations for interest rates in our crystal ball model.

And therein lies my mental model of investing vs speculating. When I’m investing, I’m making a prediction of the future earnings, with the expectation that I’ll get those future earnings one way or another (dividends, liquidation, stock price increase, etc.). The exact method that the earnings is received doesn’t really matter, and importantly, some of these methods (such as stock price increases) may incorporate speculative profits/losses from others.

When I’m speculating, I’m making a prediction of other people’s predictions.  When I buy for speculation, I’m predicting that other people predict the company will be worth more, regardless of whether it’s because they are investors (and thus predict more earnings than the current price indicates) or speculators (and thus predict that yet other people predict an even higher price).

If you are investing, you need to figure out the fundamentals of that company.  You need to know what the earnings are, whether they are sustainable, whether the company is sustainable, etc.  And then you need to make a guess on the future interest rates, and finally discount everything to present.  If you can buy the company for a better price than your result, you should (3).  Otherwise, you shouldn’t.

So think about your own “investment process”, as well as the process of people you listen to for investment advice.  Are you/they doing these?  Are you/they investing or speculating?

I have nothing against speculation — I do it myself all the time, and I believe it is an important component of a fully functioning market.

But there is a dramatically different mindset when you are investing vs when you are speculating.

Don’t conflate the two for an instant, or you may end up confusing or lying to yourself, to detrimental results.