How Does Investing Differ From Speculating?

For many people, the simple concept of spending one’s own money on something in anticipation of selling it later at a higher value is perceived to be the fundamental principle behind any choice related to financial products or assets. However, the reality of the complex world of finance is quite different, with no two choices exactly the same, and any given option potentially representing something very different to each person who considers it. Although many financial choices share some characteristics, the biggest differentiator among all of them isn’t a regulation or an asset class or an interest rate. It’s you – the investor.

You may have heard that investing differs from speculation primarily in the amount of time you intend to hold on to your investment, but at its root, this is really a question of risk. Generally speaking, assets tend to offer higher short-term gains when they are exposed to a higher degree of volatility, and are thus a representation of higher risk to the investor. Speculation is considered to be on this end of the spectrum: buying something in anticipation of rapid appreciation followed by liquidation. Investing, for most people, tends to be viewed as nearly the opposite: purchasing something in anticipation of a modest gain over a longer time period. The missing piece from these oversimplified descriptions is the impact of these choices on the investor who makes them – not only in terms of potential gain or loss, but also in terms of comfort level, knowledge level, impact on goals and milestones, and other personal factors. That’s why a comprehensive financial plan should be designed to consider a wide variety of financial choices in support of an individual’s goals, and must be created with a keen eye to the risk tolerance level of the investor.

One fantastic advantage you gain from making a financial plan early in your career is the level of flexibility inherent in a long period of time. While it is not uncommon for individual investors to simply put a manageable amount of money into very conservative investments at predictable intervals over time, this approach is a general one, not necessarily based on the goals or risk tolerance of the investor. For example, many people believe that the best way to use discretionary spending (as opposed to an established retirement plan, such as a 401(k)) to support their retirement is to make the most conservative investments possible, allocating a set amount per month to a decades-long process of accruing a portfolio of stable yet lower-yield financial products. While that approach certainly sounds smart to many people, it is, like any boilerplate plan, not necessarily the best choice for everyone.

In order to make a truly comprehensive financial plan, you need to account for more than just financial products – you need to account for you. Knowing your risk tolerance and defining your goals plays a critical role in making a personalized financial plan, and can reveal significant deviations worth making from a more general strategy based only on one’s age and income. Let’s continue to use the example of retirement as a goal for conversation’s sake. If two individuals of the same age, who both want to retire at the same age with the same amount of money, and who both have the same present income, were to make general plans based only on those factors, the results could be quite similar on paper. In practice, the difference could be very significant. Let’s say that individual A plans to retire at 62, feels comfortable having a specific amount of money available at that time, and earns a great salary now. Let’s also say that individual A chooses the generic approach we described above, simply planning to put 15% of their net income in very conservative investments until retirement. Individual A intends to follow this routine like clockwork until their 62nd birthday, and feels relatively confident that it will yield the outcome they desire. It certainly may; although all investing carries some risk, this is an extremely conservative, unwaveringly consistent approach. Individual A doesn’t consider themself a particularly knowledgeable investor, and they would probably otherwise be depositing these funds in a savings account, so they like to play it on the safer side.

Now let’s say that individual A makes a detailed, comprehensive, personal financial plan instead. They already know the basics, but in this scenario, individual A starts by determining their true risk tolerance. As it turns out, their tolerance is moderate – not a person who is likely to go skydiving anytime soon, but outside the most conservative end of the spectrum. With that in mind, individual A can look at their investing timeframe a bit differently.  For example, based on their income, the very conservative, formulaic approach described above may be able to satisfy individual A’s stated goal with only 10% of their net income earmarked for the purpose. Since they are slightly more tolerant of risk, the additional 5% they were planning to contribute could be used for investments that carry somewhat higher risk – while potentially also being capable of yielding a higher return. Individual A never thought about investing on those terms before; they never considered that they could feel comfortable in their retirement plan and also have flexibility to make educated choices that could offer higher growth. Individual A might even be starting to have a little bit of fun in this process, for once something they were definitely not prepared for.

Even if additional choices made with the 5% contribution do not outperform the most conservative ones made with the other 10%, individual A already has determined in their financial plan that their goal should be achievable with the 10% of their net income they will put into very conservative investments. If the 5% of their monthly contribution that goes to more aggressive choices yields significant results, their goal may be able to be updated as a result. Individual A may not be concerned with having a more comfortable retirement than they had initially planned for, but retiring earlier might be a very attractive idea for them. As their goal approaches, their strategy can be shifted to a more conservative one, with their initial goal accounted for and even exceeded thanks to an adaptable financial plan based on individual A’s real life.

And what of individual B? Let’s say that individual B makes the same plan, with the same results. Although individual B may be very happy to retire earlier than they anticipated, individual B may indeed have a very low tolerance for risk. If their true risk tolerance score is significantly lower than that of individual A, even though the outcomes of their common strategy are identical in this scenario, individual B might find that they are constantly concerned about the risk level of their portfolio. If so, they could spend the rest of their career planning for a great retirement while tending a daily sense of anxiety. Nobody wants to live like that!

Individual B would most likely be better off putting their monthly 15% in highly conservative investments – they could even consider contributing more than 15% to this plan earlier on, giving them a head start on accruing interest and building to their goal. Since the investment choices in individual B’s portfolio are as conservative as they come, individual B feels comfortable contributing a few percent more per month for a few years. Who knows – if individual B reaches their goal early thanks to a plan based on higher contributions earlier in their career, they might eventually find themselves considering slightly more aggressive investments with their allocated slice of income once they know their goal has already been met.

The point is, for individual B, just as for anyone else, comfort level is a key factor in planning a long-term portfolio. In individual B’s scenario, having met their goal early, perhaps they would then consider investing in an obscure company that has tremendous potential known only to people like individual B, who have spent their entire career in that company’s particular niche. Individual B believes strongly, based on thirty years in the field, that this company is going to be a breakthrough success. Individual A would probably call that speculation and be terrified of having it in their portfolio! Even if that company enjoys amazing, consistent gains, now it would be individual A who feels outside their comfort level, possibly even amplified further by the fact that they have met their original goal already. Why take the risk now, right? It’s time to retire and settle down!

Ultimately, how you choose to invest your money should always be a very personal decision. Planning based on basic figures can only account for the most rudimentary factors that you should consider.  Your personal financial plan should be a complex, flexible strategy that is capable of shifting courses as your priorities and balances change with time. Most importantly, it should be based on the things you won’t find on a ledger or an account statement – what you want to do with your life, and your comfort level with the choices you could make to get you there. Whether you view any particular financial option as an investment or pure speculation is largely determined by those unique aspects of your personality and your knowledge. For many of us, a diverse set of choices within our own spectrum of acceptable risk potential offers us the ability to feel comfortable with our trajectory toward our goals – while also giving us the potential to realize more upside than we may have considered possible within our risk tolerance. Many choices that would seem like speculation to one investor could be seen as sensible investment decisions by another, but an overall plan that involves a diverse set of choices within your personal comfort level range can help you plan your choices in greater depth and dimension. When you feel comfortable without feeling like you are missing opportunity, you’ve done well.

If you want to learn more about investment planning, determine your individual risk tolerance score, or get a complimentary financial analysis to see how your current plan works with your risk tolerance, contact BFA Wealth Management today. Let’s talk.