From our trading desk Investing versus speculating: is it worth the risk? Shaun van den Berg Head of Client Education PSG Wealth
Many investors are confused by the terms investing, trading, speculating and gambling. They may see these as being the same thing when they are in fact four different approaches. As a tool to help you explain this to clients, below is a summary of the key differences.
Investing or trading – it comes down to your time horizon and your behaviour The main difference between investing and trading is the time horizon chosen. A trader prefers a short time horizon (anything less than three years), while an investor looks at anything over three years. Although both approaches attempt to profit from a financial transaction, they are very different. The main objective when investing is to build wealth over the long term by buying and holding a diversified portfolio. Many share investors lean towards fundamental analysis by concentrating on financial ratios such as price-earnings (P/E) ratios, return on equity and interest cover to help them find undervalued, quality shares with manageable risk. Investors aim to grow their capital over time, supplemented by reinvesting profits and dividends. They will typically hold their shares through inevitable market fluctuations (with the expectation that the market will recover) and invest consistently year-in and year-out. A trader, on the other hand, buys and sells shares more frequently to try and make (and take) quicker profits. They either buy low and sell higher, sell high to buy back at a lower price (when trading derivatives such as single stock futures) or buy high and sell higher (momentum trading). Traders also prefer to use technical analysis to find high-probability trading setups. When a trade goes against them, disciplined traders exit the trade quickly to minimise losses by using protective stop-loss strategies.
Trading is not the same as speculating The main difference between trading and speculating is the amount of risk you take. Typically, high-risk trades that are similar to gambling are classified as speculation, whereas lower-risk trades based on technical analysis fall into the category of trading. Trading can result in significant financial loss if you do not know what you are doing. Disciplined traders use stop-loss strategies and position-sizing techniques to manage the risk on each individual trade. They also hone their skills by reading technical analysis books or attending trading seminars. Ultimately, prudent traders look for situations that present high rewards but low risk.
When it comes to speculating, the risk of significant loss is offset by the possibility of a huge gain. Speculators are aggressive traders who take big risks – especially when anticipating future price movements – in the hope of making quick, large gains. As such, speculators must have expertise in the instruments they are trading. These usually include highly leveraged investments such as single stock futures and contracts for difference.
Speculating and gambling While often confused with gambling, speculation involves a calculated risk and is not dependent on pure chance. Gambling, however, depends on random outcomes. Speculators make an educated decision on the direction of a trade, but the risk inherent in the trade tends to be significantly above average.
A long-term approach is always an asset There are generally two types of people: those who seek short-term or immediate gratification, and those who seek long-term gratification. A novice investor may achieve a quick profit on one or two shares over a short period of time. However, the chances of making these kinds of profits consistently without properly understanding the mechanics of the market or having an investment strategy are very slim. In fact, this approach is reliant on hope and luck as a strategy, which isn’t very different from putting all of your money on black at a roulette table. On the other hand, a prudent investor is patient and disciplined. They understand that success is nurtured with hard work over time. This investor is always on the path of continuous improvement: learning about successful investment strategies, researching companies that interest them and staying on top of what is happening to the shares in their portfolio. Their efforts are rewarded by long-term success, which takes skill and dedication.
Encouraging clients to be prudent Some clients like to invest, others like to speculate and some just dabble in the markets on an ad hoc basis. We know that a lot of your valuable time is spent communicating with clients and so we hope that this provides a useful tool to help educate your clients about the different approaches. We hope that this provides a foundation for them to be receptive to your guidance and expertise about how to maximise their returns relative to the risk that they take.