When does Investing become Speculation?

These terms are flung around so often. But what do they really mean? John Rekenthaler, vice president of research for Morningstar, attempts to answer this question.
By Morningstar |  19-02-20 | 
 

Last week, The Wall Street Journal documented how cryptocurrency owners were defrauded of $4 billion in 2019. My initial reaction was, “Well, that’s what they get for speculating.” My second thought was to retract the first, because my criticism had begged the question: What exactly is “speculation”?

Some sources treat all investments as speculation.

Cambridge Dictionary defines speculation as “buying something hoping that its value will increase and then selling at this higher price in order to make a profit.” By that measure, buying Treasury Bills is speculative. That uses the term so broadly as to deplete its meaning.

Most, however, maintain that speculation occurs when assuming high risk.

Merriam-Webster says speculation is assuming “unusual business risk in hopes of obtaining commensurate gain.”

Collins Dictionary considers that act as “making very risky investments in the hope of large gains.”

For Investopedia, speculation involves “conducting a financial transaction that has substantial risk of losing value but also holds the expectation of a significant gain.”

What’s missing is the nature of the payoff.

A wager that has an 80% chance of losing $100 and a 20% chance of gaining $1,000 is very different from a wager that has an 80% chance of losing $100 and gaining $400, because the former has a positive expected return, while the latter does not.

Yet both gambles are speculation, according to Merriam-Webster, Collins, and Investopedia, because each involves high risk, with the possibility of a large gain.

Those two wagers don’t belong in the same bucket.

The first is an investment. To be sure, it is almost absurdly risky, losing the entire $100 stake four times out of five. However, its average expected return is outstanding, being double the outlay.

In contrast, the second wager rates as speculation, because its expected payoff is less than the expenditure. Making that bet is akin to purchasing a lottery ticket; the buyer succeeds by being lucky rather than smart.

In practice, of course, expected returns cannot be so precisely calculated, even for government bonds. (It is possible, if unlikely, that the promise of the Treasury will prove false.) Therefore, they must be estimated.

Which leads to my definition of an investment: An expenditure that can reasonably be determined to have a positive expected return. In contrast, speculation occurs when the return is too uncertain to be estimated, or if the estimate can be made, but is negative.

This definition, I confess, is greatly oversimplified.

It ignores wealth effects. Despite its positive expected payoff, the first wager must be downgraded to speculation for the person who only has $100 to lose.

It overlooks the benefits of diversification, as repetition makes the first gamble increasingly safer (and the second gamble increasingly more dangerous).

It doesn’t address the risk-return relationship. Securities with barely positive expected returns and extremely high volatility are speculative--unless their performance is negatively correlated with the rest of one’s portfolio, in which case the investment may be warranted. Further complications!

However, for assessing whether my initial characterization of cybercurrency purchases was accurate, the shorthand version will suffice.

The surest investment is that which pays cash.

The distributions may be explicit, as with bond coupons, stock dividends, or rental receipts; or they may be implicit, as with the discounts that are built into Treasury Bill prices. Either way, they generate cash payments that may reliably be estimated and summed, while accounting for the likelihood of defaults.

Next come items that could pay cash, but do not. Examples include the equities of profitable firms that do not declare dividends, and properties that are used by their owners, rather than leased to others. Valuing these securities is little different than valuing those that already generate cash. The one additional wrinkle is the possibility that management will never make distributions. That prospect must be considered in the analysis.

One step further down the investment ladder are assets that cannot yield cash in their current form--for example, undeveloped land. Clearly, such properties can be speculative. Buying Florida swampland on the vague belief that someday, in some way, that real estate will become valuable is the essence of speculation. However, they also can be investments. By my book, acquiring the land near railway stations, as commonly done during the 19th century, was not speculation. Those were investments, based on shrewd calculations of incipient demand.

One could also buy cashless land based on the insight that it may contain something of value that has escaped others’ attention. If a particularly skilled geologist realizes from examining geographic features that a tract has a higher chance of possessing minerals than their peers believe, and purchases it for that reason, that transaction rates as an investment. It’s not speculation when you know the numbers and others do not.

Which brings us to cryptocurrencies.

They belong with gold bullion, diamonds, wine bottles, and oil paintings as items that will never generate cash. They will not pay coupons, declare dividends, or receive rents. They do not possess hidden resources. Their value lies solely in how they are perceived. They are worth what others will pay for them, no more and no less.

If owned in moderation, as part of a larger portfolio, such assets can be investments. Their expected returns often struggle to be barely positive--the real return on gold over the past several centuries is deeply unimpressive--but they do offer significant diversification. In addition, cryptocurrencies do have a purpose, being a method of payment.

My judgment: If somebody was defrauded while using cryptocurrency as one portion of a highly diversified portfolio, bad luck. That was an investment loss. I also will not judge those who were bilked while using cryptocurrencies for transactions, as they were designed to function. Perhaps their faith in the new currency was misplaced, but they were not speculating.

However, those who bought their cryptocurrencies believing that they would reap profits because somebody would pay them more, and then were cheated from their assets, were speculators. Plain and simple. They had no way of knowing if their purchases had positive expected returns, nor (obviously) did they possess any special insights. They were the suckers at the table.

But I still take back my initial reaction. Speculators don’t deserve to become rich, but neither do they deserve to be duped. May the perpetrators be apprehended and jailed.

This article initially appeared on Morningstar.com and has been written by John Rekenthaler, Vice President of Research for Morningstar.

Add a Comment
Please login or register to post a comment.
<>
Top
Mutual Fund Tools
Feedback