What is the difference between speculation and investment
All investment strategies in securities can be divided into three types: speculation, active investment and passive investment.
There are no generally accepted definitions, and it is not always possible to draw a clear line. In addition, approaches can be combined: for example, the main part of the investment portfolio should be allocated to passive investments, and the rest to active strategies.
Index vs active management
Warren Buffett is one of the richest people in the world, an active investor. He is a student of Benjamin Graham, who developed a strategy for value investing – that is, the search for undervalued stocks.
But even Buffett believes that passive investment in index instruments is more profitable than active management of securities. To prove this, he made a bet with Protégé Partners in December 2007. Buffett bet on the index and Protégé Partners on active management.
Buffett chose the S&P 500 index fund. This fund simply repeats the structure of the S&P 500 stock index, which includes shares of about 500 of the largest US companies. The management company does not try to show a return higher than that given by the index.
Protégé Partners chose five funds, who spread the investment among about two hundred hedge funds managed by experienced professionals. Their task was to show returns for the period from 2008 to 2017 higher than the S&P 500 index fund would have given.
At the end of 2017, the ten-year bet ended. Buffett won: The fund he chose, which simply tracked the S&P 500, rose almost 126% in ten years. The best fund of funds, Protégé Partners, returned less than 88%, and the worst returned less than 3% over ten years.
The average annual growth of the S&P 500 index fund was 8.5%, and active funds – from 0.3 to 6.5%. Actively managed funds have lost due to management errors and high costs.
Now consider the difference between speculation, active investment and passive investment. I repeat that this division is largely arbitrary.
Betting results from Buffett’s letter to Berkshire Hathaway shareholders, 2017
This is exactly what is usually called trading or playing on the stock exchange. People who discuss short-term price changes can be both speculators and active investors who have too much free time.
Speculators try to capitalize on asset price fluctuations. To do this, you need to predict where the market will go – price changes and trends are important here.
Investment horizon. A trader owns assets for a short time, from seconds or minutes (scalping and intraday trading) to several months. Accordingly, transactions occur frequently and brokerage commissions significantly reduce profitability.
Tools. The choice of assets for investments can be made with the help of technical analysis – the study of price charts and trading volumes. Speculators are also interested in news, macroeconomic situation, company reports. This must be monitored constantly.
Diversification. Investments of speculators are often poorly diversified. It happens that a trader trades only one or two stocks or futures for a long time. On the one hand, this allows you to study certain tools well, and on the other hand, it seriously increases the risks.
Results. Sometimes it is possible to overtake the market. Some speculators make good money for years, including on the mistakes of other traders. Success requires deep knowledge of the stock market, a lot of experience, and it also takes a lot of time – up to several hours a day. It is difficult to earn money by speculation, especially since it is stable to earn money for years.
Often the result of playing on the stock exchange is the loss of invested money. There is a scientific study on the Taiwan Stock Exchange from 1992 to 2006. It follows that only 15% of intraday traders were in the black, taking into account brokerage commissions, and less than 1% of traders showed outstanding profits for at least a few years. Most either stayed with their money or lost money. Unfortunately, I have not seen similar studies on the Moscow Exchange.
Taiwan Exchange Intraday Trading Study PDF, 2.7 MB
An active investor also wants to have a return above the average market, and for this he chooses individual stocks – undervalued or with good dividends. Buffett made his fortune in active investing, but it’s hard.
Investors do not typically trade with borrowed money or short, but there may be exceptions. Derivatives market – these are futures, options – are rarely of interest to active investors.
Investment horizon. Unlike a speculator, an active investor usually invests for a longer period – years and even decades. In this case, transactions are made less frequently than in speculative strategies.
Tools. An important tool in the arsenal of an active investor is a fundamental analysis of companies, that is, studying the financial condition of a business, reading reports. If a speculator is interested in price changes, then an investor is interested in a share in a good business and income from it in the form of dividends or growth in the value of the company.
Diversification. The portfolio of an active investor is usually well diversified, the money is invested in companies from different industries and even different countries. This increases the chances of success by reducing risks.
Results. An active investor can receive a higher than average market return, but this is very difficult and not everyone can do it. Even large actively managed funds lose out to the index in the long run, as Buffett’s bet showed.
To study reports and select papers, certain knowledge is needed. It takes several hours a week or a month to manage an investment portfolio.
Being an active investor is safer than being a trader.
The main idea of passive investment is to do as little as possible and not try to beat the market. A passive investor does not make transactions with borrowed money, does not play for a fall, does not use derivative financial instruments – futures and options.
Here is what Benjamin Graham says in The Intelligent Investor:
The passive investor primarily seeks to avoid serious mistakes or losses. In addition, he wants to be relieved of the difficulties and worries associated with the need to constantly make decisions.
Investment horizon. A passive investor, like an active one, usually invests for a long time – for years and decades. The frequency of transactions is even lower than that of an active investor, which allows you to pay few commissions.
Tools. Most often, modern passive investors use ETFs, sometimes index mutual funds. This simplifies decision-making, there is no need to look for future growth leaders with a high risk of making a mistake. Reports, news, price charts are not studied, and momentary price fluctuations do not bother such an investor.
In the case of Buffett’s bet, betting on the S&P 500 index fund is an example of a passive approach.
Diversification. ETFs and mutual funds provide excellent diversification of investments and reduce risks: the simultaneous bankruptcy of even a dozen companies will have almost no effect on the value of investments. Thanks to the use of index instruments, the portfolio contains the entire stock market of several countries or even the whole world.
Results. The return on investment will be the same as the market average. Since markets tend to rise in the long run, a passive investor can expect to make a profit. Giving up trying to beat the market reduces the risk of making wrong decisions, and reducing costs, all other things being equal, increases profitability.
It takes little time to manage assets, sometimes only a few hours a year. Passive investment is a relatively simple approach that does not require much time or specific knowledge.
Which way to choose?
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