Editor’s Note: This is the first of several responses to the question “what is the difference between investment and speculation?” If you are compelled, we invite you to comment below, tweet us @cfainvestored, or reach out to us via email.
The word “speculation” is commonly applied to risky investments. And the word “risky” is usually used by the masses to describe investments in assets of low quality or uncertain outlook.
On the other hand, “safe investment” is commonly associated with assets of high quality and/or those with a positive outlook. However, because of these desirable characteristics, so-called “safe investments” usually sell at high prices. And high prices have the potential to turn high quality assets into risky investments.
The more insightful investor knows that:
- “High quality” and “favorable outlook” are in no way synonymous with “good investment,” and certainly not with “safe investment.”
- It’s easy to lose money on high-quality assets; people have been doing it for years.
- Rather than quality, the greatest determinant of a safe (and profitable) investment is cheapness.
- Buying high-quality assets at high prices can be very risky.
- Low-quality speculations are usually looked down upon. But widespread derision usually results in low prices, which can make for high return potential (and good safety)
- Thus buying low-priced low-quality assets can be very rewarding. They may be called rank speculations when they’re made, but they’re often relabeled astute investments when big profits are harvested.
Let me approach this another way: John Maynard Keynes said “a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware.” What did Keynes mean? Understanding him requires some of the complex, counter-intuitive thinking that must be present if investing is to be understood.
- People who buy obviously risky assets may be called speculators.
- People who buy seemingly safe assets are likely to be called investors. But they usually pay prices commensurate with the assets’ apparent risklessness, and when unanticipated risks surface, they can come as a big – and unhappy – surprise. Unfavorable surprises tend to produce investment losses.
I think of investment results as what happens when reality collides with expectations. So-called “speculative” assets are usually the subject of low expectations on the part of the investing crowd. If those expectations are exceeded, profits can result.
But high quality investments are often premised on lofty expectations, and these are subject to disappointment. When that occurs, “investments” can turn out to have carried “risks of which the investor was unaware.”
That’s what Keynes meant. By his standard, I’d much rather be an intelligent speculator than a conventional investor.