All investments involve risk but not all risks are equal. When the market rallies, it’s easy to focus on what you could have gained by going all in on Bitcoin or buying the latest successful tech IPO. Big risk, but big potential payoff! Then comes the market correction along with the pain of watching these same holdings drop by half or more.
This discussion often comes down to a small question with big implications – are you investing or speculating? Both can have a place but come with different risks and possible outcomes. What are the differences and how can you place each one properly in your plan?
Investing vs. speculating
Let’s start by defining our terms. Forbes put it this way:
- Investment is acquiring an asset with the goal of generating income or appreciation in the future.
- Speculation is a financial transaction with substantial risk of losing all value, but with the expectation of significant gain.
The goal of investing is to substantially reduce the risk of loss. Speculation, on the other hand, requires the risk of total loss for the chance at higher gain.
Your plan should rely on investing, not speculating
How does this apply to your planning? You shouldn’t count on guessing correctly…you need reliable investment strategies to reach goals like financial independence. Answer these questions:
- When will you need the money? This determines your time horizon.
- How much do the market’s ups and downs bother you? This determines your risk tolerance and helps prepare you for short term swings in your long-term portfolio.
With these answers, we can build time-tested, data driven investment strategies with a high probability of success. While time horizon and risk tolerance are also crucial in deciding if a particular speculation is a good idea, investment strategy adds two elements:
- Diversification – not “putting all your eggs in one basket” – is your game plan for dealing with a big hit to a specific company or category of companies. Your portfolio will include investments of different sizes, industries, historical volatility, and categories. When Amazon, Google, or Microsoft, or the entire technology sector, has a bad year, you’re still in good shape because you own many kinds of companies. You can also consider assets that don’t rely on the stock market to further reduce your risk.
- Rebalancing – periodically bringing a portfolio back into balance by selling outperformers to buy underperformers – is more than simple portfolio housekeeping. It’s a systematic “buy low, sell high” practice and keeps your strategy in line with your risk tolerance.
A long-term, disciplined investment strategy has a high probability of long-term success, in part due to these practices. Speculating is a more “all in” strategy that necessarily takes the risks diversification and rebalancing are intended to mitigate.
Is there a place for speculating? Yes, just not with your nest egg – the money you need for mid and long-term goals. Make sure you’re on track with goals like retirement apart from any speculative investments. If you hit a speculation homerun, you’re ahead of the game. If you strike out, you’re still on pace for your important objectives.
So, you’re on track with your goals and want to bet a little bigger on Bitcoin or that stock you think is about to break out. Use these three tips to take measured risk.
- Set an investment limit in advance, a fixed dollar amount that you can consider your speculation bankroll. Set this boundary in advance because speculative investments can be a mental challenge, which leads to the next tip.
- Plan how you will respond to large gains or losses.
- Gain – you were right! When will you sell and take your gains off the table?
- Loss – you missed on this one. Are you willing to take a total loss and ride it out or do you plan to sell at a certain level? More importantly, don’t let good money chase bad money. Be willing to accept a loss rather than piling more money in just because it might go back up.
- Systematize your oversight plan. If you have gain and loss limits, often you can set up automatic sell orders at these limits. Or, if you prefer, decide how often you’ll check in on the investment and what you’re looking for. This can help prevent your speculation from taking more and more time from other important areas of your life.
Once you have an understanding of the differences between investing and speculating, an investment strategy to reach your important long-term goals, and a game plan for your speculation, you’re positioned to take on a new hobby with healthy boundaries.
The “Alterra” name was coined by joining the Latin roots “alter”, the origin of the word “altruism” with “terra” meaning earth or land. This name reflects the company philosophy of “clients before profits” and providing firmly grounded advice.