Investing expert David Stein explains how to identify if a financial opportunity is an investment or a speculation and why we should concentrate on those where we are more likely to be successful.
When considering a new investment opportunity, it is critical to understand whether it is truly an investment or if it is a speculation. Investments are financial opportunities that have a greater likelihood of being profitable, usually because they have an income or cash flow component to them, such as dividends, interest, or rent. Examples of investments include stocks, bonds, and rental real estate. Investments have a positive expected return.
Speculations are financial opportunities where there is some disagreement over whether the return will be positive or negative. To make money with a speculation, someone has to be willing to pay more than what we paid because there is no income associated with the opportunity. Examples of speculations include gold coins, commodities, art, cryptocurrencies, and antiques.
Speculating isn’t bad, but the vast majority of our retirement savings should be focused on long-term cash flow–generating investments where success isn’t dependent on outsmarting other investors or hoping a non-income producing speculation will be bid up in price.
Earlier this year, I met a furniture salesperson who was confusing speculation with investing. He paid an academy $23,000 to learn how to trade commodity futures and currencies. He said, “You have to invest in yourself.” This sixty-five-year-old man had worked at the furniture store for fourteen years and had never participated in his employer’s defined contribution plan, where he could effectively earn an immediate 100% return because the company matched employee contributions dollar for dollar. The man said stocks were too risky. Now he had turned to speculative trading so he could earn enough to retire in five years.
I attended a four-hour workshop at the trading academy the furniture salesman had joined so I could better understand how the academy was able to convince a man with little investment experience to pay such a large sum to learn how to trade. The way to be a successful trader, the instructors at the academy said, was to exit losing trades quickly and let the winners run. They emphasized that if traders make significantly more money on the winning trades than they lose on losing trades, then they need only be right a little over half the time.
In their U.S. patent, the academy shared the secret to their trading process. They pointed out that trading is a zero-sum game in that for every winner there must be a loser. Consequently, successful traders are the winners who exploit naive traders who are the losers.
This furniture salesperson exemplifies a pattern I often see with new investors. They want to learn to invest, but rather than learning the basics of how asset classes such as stocks and bonds work, they get caught up in the latest speculative craze, be it cryptocurrencies or trading forex. More often than not these individuals end up being the naive traders who are exploited by others.
Classifying a financial opportunity as an investment or speculation is a simple way to narrow down the universe of potential financial opportunities so we can concentrate on those where we are more likely to be successful. Investments generate cash flow so the investor’s return is not entirely dependent on the asset being bid up in price. Of course, with any investment we need to be wary that we are not paying too much for that cash flow stream.
I share additional insights on how to identify profitable investments in my book, Money For the Rest of Us: 10 Questions to Master Successful Investing.