Investment vs Speculation: Objectives and Decision Process
Investment vs. Speculation
Investment: Investment is an activity engaged in by people with savings. Investments are made from savings; people invest their savings. However, not all savers are investors. Investment differs from saving. Investment is defined as “a commitment of funds made in the expectation of some positive rate of return.”
Understanding Speculation
Speculation: Speculation involves risky financial transactions to profit from short- or medium-term market fluctuations of a tradable good, such as a financial instrument. This contrasts with profiting from the underlying financial attributes embodied in the instrument, like capital gains, interest, or dividends. Speculators often focus on price movements rather than the fundamental value of a security. Speculation can involve any tradable good or financial instrument and is common in markets for stocks, bonds, commodity futures, currencies, fine art, collectibles, real estate, and derivatives.
Key Differences Between Investment and Speculation
- Investment focuses on value creation, while speculation is concerned with price movement. Speculation profits purely from price differences, influenced by market psychology.
- Investment has lower risk but requires more capital to generate value. Speculation is more challenging, has higher risk, but requires less capital, making it more accessible.
- Investment involves accepting what the market offers, while speculation tries to beat the market.
- Investment involves less activity, letting companies or industries work for you. Speculation involves more activity.
- Investment is long-term, while speculation is short-term. Success in speculation peaks when positions are kept open for the shortest time possible, offering perceived “shortcuts” to wealth.
Investment Objectives
Safety
Some products are preferred by risk-averse investors.
Growth
Many investors aim for capital gains, seeking growth in the invested amount. Several market options offer this benefit.
Income
Some individuals invest to generate a second income source, investing in products that offer regular returns, such as bank fixed deposits, corporate, and government bonds.
Other Objectives
Tax Exemptions
Some invest in financial products solely to reduce tax liability. Some products offer tax exemptions, while many offer tax benefits on long-term profits.
Liquidity
Many investment options are not liquid, meaning they cannot be sold and converted into cash instantly. However, some prefer options that can be used during emergencies.
Investment Decision Process
A typical investment decision involves a five-step procedure known as the investment process:
1. Defining Investment Objectives
The objective is to make money while accepting the risks involved. Typical objectives include current income, capital appreciation, and safety of principal.
2. Analyzing Securities
Analyzing securities helps investors distinguish between underpriced and overpriced stocks.
3. Constructing a Portfolio
Portfolio construction involves:
- Allocating the portfolio across different asset classes, such as equities, fixed income securities, and real assets.
- Asset selection decision.
- Execution.
4. Evaluating Portfolio Performance
Performance evaluation is done in terms of risk and return. Evaluation measures are developed.
5. Reviewing the Portfolio
This involves periodically repeating the above steps. An investor’s objectives may change over time, and the current portfolio may no longer be optimal.