Are You A Speculator Or An Investor?

The difference between speculation and investment

What are the key differences in behaviour that help define the distinction between speculators and investors? What do your behaviours say about you?

Speculation has been defined as the assumption of risk in anticipation of gain. Compared to investing, it tends to be associated with higher risks and achieving quicker and larger gains. It generally involves a “bottom up” approach that treats each risk as separate and distinct. It includes elements of stock selection, market timing and forecasting.

Investment, on the other hand, employs a “top down” approach that avoids focus on the separate risks and short term outcomes in favour of a focus on the characteristics of the whole portfolio.

A casino analogy

A good example for highlighting the distinction between investment and speculative behaviour is the interaction between a casino operator and its players. The behaviour of the casino operator is likened to that of an investor and the player to that of a speculator.

Casinos rely on getting an outcome in line with their expected advantage. For example, their payouts are set at (say) 97% of the fair odds for each bet. Accordingly, they expect to get a return of 3% on each bet.

Of course, there’s no guarantee that the casino will get their expected 3% return for any game or on any given day. This is what makes it such an alluring proposition for the player.

The casino operates on the principle of the Law of Large Numbers. This says that as the number of trials (bets) increases, the average return should converge towards the expected return (3% per bet). As the casino’s return converges towards the expected return (3%), the collective return of all players converges towards the opposite of that return (-3%).

Casinos tend to have more longevity than their players. While they may experience some extreme movements in their short term returns, they are prepared to diversify their risk across players and games. They don’t care who is winning or losing as long as players keep betting. They take a broad and long term perspective.

The players’ behaviour on the other hand is quite different. Each bet is seen as a separate and distinct bet. They use various complex betting strategies involving forecasting, trend following, hedging and leverage. They are optimistic about their abilities to make money in any game. This is despite the fact that as a collective group, their average return will converge towards -3%.

Access to information is often considered a key ingredient to successful investing. How does this apply to the casino analogy?

You can imagine the casino has the ability to easily tell which numbers on a roulette table pay out more frequently. Surely, with this (privileged) information they should be able to easily add value by adjusting the specific odds to their advantage (e.g. by shifting the odds to encourage players to bet on less successful occurrences).

Yet, they don’t bother to change their payout odds. Most speculators would consider this a missed (golden) opportunity. Yet the casino behaves as if the specific outcomes of each event don’t even matter.

The behaviour of the players infers a belief system that says they can defy the odds. In fact, its highly probable that an individual player will be well ahead for a period of time. Its equally probable that that individual will be well behind for a period of time. However, the more often they bet, the more they become subject to the Law of Large Numbers.

There is no magic that allows a specific group of players to systematically out perform the odds without relying on others to systematically under perform.

Lessons investors take from casinos

The behaviour of investors (casino operators) and speculators (casino players) in investment markets (gambling) has many similarities. If you substitute the names in the above text you’ll get an idea of the key differences.

Given that most people will have a lifelong association with investment markets, we recommend they take advantage of the Law of Large Numbers and adopt the behaviour of an investor:

1. Take a long term view and allow the Law of Large Numbers to work for you. The aim is to achieve the expected rate of return for the least cost;
2. Avoid the allure of opportunities that attempt to defy the odds (e.g. low risk, high return promises). Speculators provide liquidity to the market and spend most of their time trading with (and against) each other at a much higher cost;
3. Choose your risk strategy carefully and change it rarely;
4. Avoid getting caught up in short term returns. Be prepared to accept some volatility;
5. Don’t bother trying to predict short term pattern anomalies; and
6. Diversify across investment options and across time.

While the speculator may appear to be having more fun and employing more “intelligent” strategies, it is the investor that is playing the game with real intelligence and achieving the more certain and efficient long term return.

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