The difference between speculating and investing

Most people would feel that they understand the difference between “speculating” and “investing”, but it’s amazing how often we hear the words used interchangeably. While they might seem similar on the surface, when you dig a bit deeper it’s like mistaking 20/20 cricket and Test Cricket.

If you buy a mining exploration company or tech startup you’ve read about online or on social media, you might feel as though you’ve “invested in the sharemarket”. The truth is that the value of many of these companies is highly uncertain and impossible to measure objectively. Most of them don’t generate income, and are unable to pay dividends to shareholders.

Usually when someone buys shares in one of these types of companies they’re hoping to trade out within 12 months (often sooner!) for a short-term profit. Rather than investing in the long-term prospects of the company, they are speculating on short-term share price fluctuations.

What is the difference between speculating and investing?

Investing is typically a long-term strategy, based on fundamental research, that involves holding assets for years. Warren Buffett famously said that his favourite holding period is “forever”.

Speculating, on the other hand, is usually a short-term strategy that involves buying and selling assets quickly in the hopes of making a short-term profit. It is often based on ‘gut feel’ rather than fundamental research.

These two different approaches typically mean speculating is a higher risk activity – as predicting short-term movements in prices is usually a coin flip – whereas investing is far more likely to produce good returns over the long term.

Buying speculative companies can in some cases be based on “the greater fool theory”. This is where you buy an asset where there is questionable intrinsic value, hoping that someone buys it from you for a higher price. This type of behaviour is common when asset classes are popular and their trading prices have risen sharply. This momentum can give speculators false confidence prices will continue to rise.

We saw this over the last few years with bitcoin and other cryptocurrencies. Cryptocurrencies might be useful, but outside of the underlying block-chain technology, they have no discernable intrinsic value. They can’t be valued objectively and they trade based on faith, rather than fundamentals.

Investing in the sharemarket is based on fundamental analysis and valuation

Fundamental investing in the sharemarket involves taking a long-term approach, and buying a diversified portfolio of quality companies, below their intrinsic value.

Quality companies can grow their profits over time and generate a sustainable and growing income stream. With competent management, good-quality companies will use the cash flow generated and retained in the business to compound their worth.

To illustrate the difference between speculating and investing consider the performance of two companies over the last 10 years.

Brambles and AVZ minerals – a case study of speculating vs investing

Brambles (ASX: BXB) is a transport and logistics company, which manages the world’s largest pool of reusable pallets, crates and containers. AVZ Minerals (ASX: AVZ) is a lithium exploring company that owns rights to a large lithium deposit in the Democratic Republic of Congo (DRC).

This is a chart of their share prices over the past 5 years, from 1 July 2018 to 30 June 2023:

Brambles has been operating since 1858 and has been publicly listed since 1954. Its share price has appreciated steadily, with fluctuations, reflecting the improvement in earnings and dividends from the business over time. This steady accumulation shows the high quality of Brambles’ business and operations. IML has been a long-term shareholder of Brambles as we think it’s a well-run business, with a dominant market position and strong recurring revenues. Brambles also scores highly on sustainability metrics. It has strong governance, a good social licence to operate and also ranks well environmentally due to its circular business model of re-usable pallets and containers.

AVZ minerals, on the other hand, has had a much more volatile 5 years. Its share price was static from 2018 until the middle of 2021 and then it exploded upwards: going from 16c in mid-2021 to $1.23 in March 2022 as it rode the wave of investor excitement in lithium, without any improvement in earnings or dividends. Then things took a dramatic turn for the worse for AVZ as the government of DRC effectively sold the rights to the lithium deposit it owned. AVZ’s share price plunged, shares were suspended from trading in July 2022 and haven’t traded since. Investors now have their capital locked up in AVZ and are unable to access it. While those shares may potentially be worth something, one day, right now they are effectively worthless.

Speculators speculate, investors invest

Speculating can be a lot like gambling – high risk, high reward. It’s a 20/20 cricket match of big hits and bigger misses where anyone could win on the day.

Investing, on the other hand, is a deliberate approach to steadily compounding wealth over time. It’s a test match – calculated risks, carefully set field positions, a gradual accumulation of runs over a long summer day.

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