The rapidly rising popularity of trading apps, which encourage users to treat investing like a game, have brought these stark differences into sharp focus.
Earlier in the week, I was a guest on BBC Radio 4’s Money Box Live programme, answering listener questions about trading apps and social media investing.
The discussion was a fascinating insight into investing through the lens of relatively new, amateur investors.
While I have concerns about investors taking excessive risks and not fully understanding what they are doing, it’s generally a good thing that more people are dabbling in the world of investing.
But knowing the difference between investing and speculating could save you from a financial disaster.
I believe there are several factors that distinguish investing from speculating.
The timeframe is a key consideration.
Speculators typically focus on the short-term. If you are looking at the returns from assets in hours, days, weeks or even months, there’s a good chance you are speculating instead of investing.
Real investing is measured in years or decades. The longer, the better.
We know that investments can go down in value as well as up. But we also know (history tells us this) that, over longer periods of time, a well-diversified portfolio of mainstream investments will usually go up in value.
Another signal suggesting speculation is whether or not you own the underlying asset.
New users of trading apps are increasingly gaining exposure to the underlying investments through the use of financial instruments, including Contracts for Difference (CFDs). Rather than owning the investment, they enter into a contract with the broker to deliver the equivalent returns from that asset or market.
We know that the majority of retail investors who speculate using CFDs lose money. Each trading platform is required by UK regulations to disclose the percentage of users who lose money when speculating with these instruments. The numbers are always high, around three-quarters.
Of those who ‘make money’ by trading CFDs, the majority make very little indeed, which means it unlikely to be worth the risks involved.
Another sign of speculation is what drives the price of the asset, with investor or market sentiment the dominant factor.
Investments are driven by fundamentals, with sentiment adding a little in the way of market volatility or price inefficiency.
If what you’re buying is going up in value simply because everyone else is piling in (think Gamestop or Bitcoin), rather than because the investment is inherently worth something, then it is likely you are speculating.
The moment that sentiment turns negative, the price of the asset usually collapses.
The value of genuine investments is usually driven by their future cashflow; without income-generation, I would argue that something isn’t a real investment.
A non-income generating asset (and that includes gold and cryptocurrencies) is speculation rather than investment.
What other warning signs would you add to this list, to help newer investors understand the difference between speculating and investing?