This post may contain affiliate links. If you make a purchase through my links, at no cost to you, I may get a commission.
How do you know when you are making an investment versus a speculation when putting money in the stock market?
The media portrays the market like it’s a bunch of random numbers that fly across your screen.
People like Cramer come along and tell you when to Buy, Buy, Buy or Sell! And have crazy sound effects to go along.
You like to think that you’re making an informed decision, but let’s be real.
Are you really going to drop your hard earned money into a company because some guy or gal on TV said so?
I don’t care if the guy is Warren Buffett himself.
You don’t know him and he doesn’t know you.
These people on tv and investment gurus on social media don’t owe you anything.
They talk about how if you get your mind right and have an abundance mindset you too can make $1,000,000 this year by buying their course.
It’ll only cost you $2,000 a month but you’ll be driving a lambo and making so much money that the cost doesn’t matter.
If you look at this blog or the Talkvest Twitter account you’ll see there’s some dealing with mindset because that’s important and a lot about business.
Yes, there is a good amount about investing too.
When you’re investing in the stock market your buying a piece of a business.
It makes sense then to understand at least a little about business if you’re investing in the stock market.
That’s what will separate you and your investing journey from someone that blindly signs up for Acorns or Betterment because someone on the internet told them to.
Warren Buffet says he likes to invest in what he knows.
That’s one lesson that tends to get lost in investing today.
Speculation
If you’re blindly putting money into anything you’re speculating.
Even your 401k at work.
You probably know someone that thinks all investing in the stock market is speculation.
Gambling.
That it’s all a scam to take your money.
You know there’s a way to put your money to work.
So let’s go over the difference between investing and speculating.
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” -Ben Graham, The Intelligent Investor
What that means in today’s English is you have to do your homework before putting your money to work.
Through your analysis of a company you have to feel confident that your investment will provide returns.
If you don’t understand the business behind the stock and how they make money, how can you expect to make money investing in them?
You can’t.
Maybe you’ll still make money, but it’s because you got lucky.
You picked the right horse at the track.
Even in your job when the financial person comes in wearing their fancy suit and explains why you need to start saving yesterday and here’s a giant stack of papers you should go through and just pick a fund.
You don’t really know where your money is going.
You just know you don’t have access to it until you’re retirement age.
Hopefully it’ll still be there and this guy in a suit was right and you’re secretly a millionaire.
But if there is a downturn right when you hit retirement age and a good chunk of your savings is gone, then what are you going to do?
Evaluating a business
When you can buy and sell shares in the market that company is a public company.
The general public can buy into the business and be part owner.
Public companies are required by law to publish their financials in what is known as a 10k.
And yes sometimes reading one feels as long as running one.
Probably both good for your health though and I’m no fan of pounding the pavement.
“The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition.” -Benjamin Graham, The Intelligent Investor
It’s a lot harder to invest in a new company because they don’t have the track record.
In the case of something like Facebook or Amazon where you know they’re going to take over the world, it might be a good idea to speculate a little.
Just don’t be totally surprised if the company you’re putting money in ends up like MySpace instead.
Speculation in Stock Market Prices
People like to think today that all stocks are accurately priced.
That when you’re investing you’re only in it for future growth.
That’s a load of BS.
When there’s an oil spill why do all the oil stocks go down?
Not just the one with the spill?
If someone like Coke or Pepsi misses earnings why does the whole beverage sector drop a little?
What does that have to do with Monster if they beat theirs?
Why do
Even in a market drop, what changed in each business from one day to the next?
Often it’s nothing.
The companies that we’re making money yesterday are still making money today.
“To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.” — Benjamin Graham, Intelligent Investor
Benjamin Graham notes it in the beginning of The Intelligent Investor.
You have to be contrarian if you want better than average returns.
Because industry professionals have the same or better data than you do.
And they still generally don’t beat an index fund.
Speculation in Real Estate
People love to speculate in real estate when prices get hot.
Just look how popular fixing up a home and flipping it becomes to figure out where we are in the cycle.
If no one wants to do it, home prices are probably cheap.
If everyone and their mom is flipping we’re probably in a bubble.
Speculation in Cryptocurrency
Most of what’s going on in cryptocurrencies is speculation.
A lot of it isn’t even regulated.
There are a ton of crypto coins out there that we’re only made to get the creators rich.
In 2017 it looked like the gold rush.
I think the block chain will be the way of the future.
But there’s a difference between block chain and cryptocurrencies.
And unless a cryptocoin is useful it won’t have any tangible value.
It’s basically a token if it’s a coin for no reason.
Subway tokens aren’t worth much nowadays.
Most cryptocurrencies will end up the same.
How to Speculate
Speculation isn’t all bad.
People like to put money on the home team to win on Sunday.
They go play the slots or game of choice at the casino.
It can be exciting.
So make sure you’re doing it right.
Don’t get it confused with investing.
A couple main things you’ll want to figure out are your expected return and how much money you should use from your bankroll.
Expected Return
Calculate your expected return to see if speculation in the stock market or putting money on Sunday’s game is even worth it.
Multiply your winnings (assuming you get it right) by the chance that you’re right and that’s the expected return.
Let’s say there was a game where you could win $5 on a coin flip.
Your expected return is $5 * 0.50 = $2.50
You can do that with anything you’re trying to make money on.
Sports bets, stocks, even the lottery.
You can get real fancy and figure out when you should play the lotto.
Hint: when your total expected return is less than the price of a ticket, it’s not worth it.
Kelly Formula
Now you’ve decided to speculate.
You figure your expected return is worth it.
Or heck you just want to throw down some cash and try to get lucky.
The Kelly Formula is a bankroll tool.
Your bankroll is how much total money you have to wager.
It tells you how much to bet out of your total based on the likelihood of winning.
Basically you’re trying to maximize results (betting more aggressive) while minimizing the chance you go broke (which is likely if you’re betting aggressive)
Wrapping Up
Most of what people are doing when they think they’re investing in the stock market is actually speculation.
I don’t think speculation is necessarily bad but don’t conflate the two.
When you’re investing you are protecting your capital and have done enough homework that you can expect a return.
If you haven’t done the work you’re not investing.
You’re speculating.
Hoping to hit the jackpot.
And there are times when you should swing for the fences.
You learned above about how mathematically to do it right.
If you would like to learn more about stock market investing, sign up for my course Stock Market Basics.
I understand if you’re not ready to make a purchase today, so instead put your email below and sign up for my free newsletter.