Investing, Speculation, and Gambling


To anticipate the market is to gamble. 

To be patient and react only when the market gives the signal is to speculate.

- Jesse Lauriston Livermore


In my view, a crucial aspect of achieving success in the financial realm is to clearly differentiate between gambling, speculation, and investing. I notice that many individuals tend to confuse these terms and lack a clear understanding of their actions. It is essential to recognize the distinctions between them.


Investing and speculating require different skill sets. An investor needs to possess a unique set of skills compared to a speculator. While both may involve financial decisions, their approaches, goals, and risk management strategies differ significantly.

If one lacks a clear understanding of their actions and the underlying principles, they are more likely to fall into the category of a gambler. This is why it is crucial to educate oneself and be knowledgeable about the distinctions between these terms.

It's important to clarify that the definitions and explanations provided for each term are my personal interpretation based on how I perceive them. Different individuals may have varying perspectives on these concepts, but I find it essential to emphasize the significance of understanding these distinctions to make informed financial decisions.

Before we delve into my understanding of these terms, let's take a look at the official definitions, and for that, let's refer to Wikipedia:



Investment is traditionally defined as the "commitment of resources to achieve later benefits." If an investment involves money, it can be described as a "commitment of money to receive more money later."


Speculation, in finance, refers to the purchase of an asset (such as commodities, goods, or real estate) with the hope that its value will increase shortly. It can also involve short selling, where the speculator anticipates a decline in value.


Gambling (also known as betting or gaming) involves wagering something of value ("the stakes") on a random event with the intention of winning something else of value, where strategy is not the primary factor.


We can see that there is some overlap between these terms. All three activities involve putting money in to make more money. However, I believe that the conventional definitions fall short, so let's delve deeper into the differences, keeping in mind that this is my own opinion.


Let's begin with Investing.

As Wikipedia shows, it is a "commitment of resources to achieve later benefits." However, one might argue that a speculator also commits resources for future gain. So, what distinguishes a "commitment of resources" as an investment? 


It is the productivity of the asset.

 

Investing is limited to productive assets.


To illustrate this point, let's consider an example:


Imagine you come across a lemonade stand during the summer that appears to be very successful. You strike up a conversation with the owner, a young teenager who runs the stand to earn some extra pocket money. During the conversation, it becomes clear that the young owner has no intention of running the stand indefinitely, as he needs to focus on school and other commitments.


Now, you step in as an investor.


The stand generates a profit of $1000 per year, mainly during the summer. You propose to buy the stand, the permission to operate at that location, and the existing inventory from the current owner. You offer $5000 for the entire setup.

The young owner is delighted with the offer, as he might not have the resources to continue running the stand for an extended period while managing school. You both sign a purchase agreement, and soon you become the new owner of the lemonade stand.

Now, you have $5000 less in liquid funds. With an annual profit of $1000, it will take five years to recoup your initial investment. However, you can increase the profit by introducing new lemonade flavors, running advertisements, and improving the efficiency of serving, thereby making the lemonade stand more valuable.

Nevertheless, every dollar you earn after recovering the $5000 investment will be a profit. You could reinvest this profit in other lemonade stands to repeat the process.


The decisive point is that as an investor, the fundamental goal is to accumulate productive assets to participate in their returns. The investor would be perfectly content never to sell the asset and profit from its returns indefinitely.


One can invest in their own or other companies. It is possible to purchase real estate that generates rental income.


But one cannot "invest" in cryptocurrencies.


Cryptocurrencies, gold, or other commodities are not productive assets. They do not generate profits. The gain in unproductive assets comes from an increase in value. The profit in these unproductive assets relies on finding a buyer in the future who is willing to pay more than you did.


And this brings us to our next term…


Speculation

For the speculator, the focus is less on the item purchased but rather on an idea. A speculator attempts to make transactions in specific situations based on their opinion about the value's development. The speculator aims to buy low and sell high or sell high and buy back low.


Thales, an ancient Greek philosopher and mathematician who lived around 624-546 BCE, is often credited with one of history's earliest recorded speculative activities. He is said to have speculated on the olive harvest, predicting a large crop for the upcoming season. Confident in his prediction, Thales secured exclusive rights to the olive presses at a low cost during the off-season. 


It's worth noting that there was no direct productivity involved in his actions; Thales did not produce olive presses himself but rather speculated on their value. 


When the harvest indeed turned out to be bountiful, he was able to lease the olive presses to the olive farmers at a much higher price, making a significant profit. Thales' successful speculation on the olive harvest is an early example of forward thinking and applying knowledge to make profitable financial decisions, showcasing the potential benefits of well-informed speculation in history.


Virtually anything can become a speculative object. It doesn't matter whether one is speculating with oil, real estate, stocks, or tulips, as long as there is a change in price, speculation can occur.


It is crucial to note that determining the probabilities of success in speculation is difficult, which is why many speculators concentrate on the risk-reward ratio. As a speculator, one should have a positive expected value to make a rational transaction. Although the outcome of each individual transaction may be random, the sum of the transactions should generate a positive result.


If the expected value is unclear, and the reasons for the transaction are undefined, I would not call it speculation but rather gambling.



Gambling

Since many people do not have a positive expected value in speculation, as they do not apply a real advantage, most speculators are essentially gamblers.


For the investor, analyzing the asset is of critical importance. For the speculator, the idea is a decisive factor. For the gambler, luck or chance determines success.


A gambler has a negative expected value, but they play anyway because there is a chance they might get lucky. The gambler also uses capital with the aim of increasing it; however, they lack a solid foundation on which to base their decisions. Instead, they make uncoordinated bets. This leads to random results.



Conclusion 

It is extremely important to define for oneself the nature of the activity one is engaged in. Believing to be an investor while actually being a speculator can lead to significant losses. There are often gamblers who mistakenly think they are "investing" in overvalued growth companies or cryptocurrencies. Such a belief in an investment can result in becoming a bagholder. Equally dangerous is following a strategy and speculating when, in reality, one is making random bets.


Investing is generally a long-term endeavor where additional contributions are made to the investments over time. Speculation aims to generate alpha, justifying the increased time commitment and risk in the long run. As a speculator, there may not be a need to invest in the speculations over an extended period, as the power of compounding cannot be matched by regular contributions (as explained in the "Formula of Wealth" post).


In my opinion, speculation is a tool to build wealth. However, one should never use essential funds, but only resources willing to be risked. Investing can preserve and grow one's wealth. Combining these two activities can be advantageous, but it is crucial to remain clear about the purpose and nature of each endeavor.



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