The difference between investing and speculation (or: The problem with Bitcoin)
Hold onto your hats, folks. It's rant time!
Based on what I'm hearing on Facebook, Twitter, and in real life, it's time for a refresher course on the difference between investing and speculation. Although these two concepts share some commonalities, they're very different things.
Let me start by telling a story, one I've told many times before. It's the story of the worst “investor” I've ever known: me.
The Worst Investor I've Ever Known
Before my financial turnaround, I didn't really understand what the stock market was for. I viewed it as a sort of casino, I guess. I believed investors gambled on individual stocks and hoped that they'd outperform the rest of the market.
So, that's what I did. I treated the stock market as if it were a casino. I'd pick a stock, put all my money into it, and cross my fingers. I took risky gambles hoping to strike it rich.
Unsurprisingly, I lost a ton of money.
- During the late 1990s, some friends and I formed an investment club. Each month, we contributed money and picked where to put it. We chose stupid, stupid stocks — whatever was riding high at the moment. When the tech bubble burst, so did our bankroll and our enthusiasm.
- In 2000, enamored by PalmPilot, I bought stock in the company that made the devices. I paid close to $90 per share. Just over a year later, the stock had lost 90% of its value. Oops.
- One of my friends worked for The Sharper Image. In 2007, the company was struggling and the stock was in the toilet. At dinner one night, my friend told me how management was trying to turn things around. Sounded promising, so I put my $3500 Roth IRA contribution into the company's stock. The company soon went bankrupt and my 2007 IRA contribution is now worth nothing.
- During the banking crisis, I invested in Countrywide Financial. “Countrywide is on your side,” right? Wrong. Yet another stock that went to zero.
I wasn't investing; I was speculating. I was gambling. I was trying to pick winning cards at the casino. But that's how I thought the stock market worked.
The High Risk of Risk
After writing at Get Rich Slowly for a while, my viewpoint changed. As I became better educated, I realized that the stock market is not a casino. It's a marketplace. It's a tool that allows people to buy shares of businesses. (This is obvious, but trust me: Most people don't understand this.)
When I buy a piece of one business, I'm taking on the risk associated with that business. We hear all the time that most small businesses don't survive seven years, right? Well, even big businesses go under. Even big businesses lose money. There's always risk associated with owning a business.
In the world of investing, “risk” is the probability that you'll lose money. (There are many types of investment risks, by the way.) The notion of “return” is fundamentally tied to the concept of “risk”. The greater the risk — the greater the chance you'll lose money — the higher your potential returns (gains) are.
One difference between investment and speculation is the amount of risk involved. When you put your money into something with minimal risk, you're investing. When you put your money into something with high risk, you're speculating. Like I said at the start, there are plenty of commonalities in the two actions — but the element of risk is a huge differentiating factor.
One way to mitigate risk is to own pieces of several businesses. Owning many businesses is even better. This practice is known as diversification. Diversification reduces risk. It allows you to enjoy the profits and benefits without getting screwed when one business goes under. This is investing. Putting all of your money into one stock and hoping that it increases in value is speculation.
A Random Walk
It's also speculation when you hop in and out of the market, buying and selling stocks in the short term like day traders do. Day traders aren't investing; they're gambling on short-term price fluctuations.
In the short term, stock prices follow what has come to be known as a “random walk”. They bounce up and down with little rhyme or reason. Over the long term, however, the stock market as a whole tends to increase in value.
Why are stocks said to follow a “random walk”? Let's look at an analogy. When I take Tally for a walk, we always follow the same route. We take a 1.85 mile loop through the neighborhood and it generally takes us 51 minutes. (Seriously, it almost always takes 51 minutes.)
However, we never travel at a constant pace. Because Tally is a hound dog, we move in fits and starts.
- Is there water in the ditch? Time to splash and sniff!
- Are there deer in the pasture? We have to stop and bark!
- Is that a new gopher hole? Let's dig!
- Wait, is that a squirrel? Let go of the goddamn leash, you jerk!
Each day is different. It might take us 20 minutes to walk the first 1/2 mile today, then we'll travel the same distance in 10 minutes tomorrow. But when it's all said and done, it takes us right at 51 minutes to go those 1.85 miles. (Sometimes we do it in 49 minutes. Sometimes it takes 54. But we average 51 minutes. And 51 minutes is the most common time to complete the walk.)
Our daily strolls through the neighborhood follow a “random walk”.
Over the short term, the stock market also follows a random walk. Both individual stocks and entire indexes fluctuate — sometimes wildly. I wouldn't care to place a bet on what the S&P will do today, or tomorrow, or even next year. But if past performance is any indication — and past performance is the best info we have to go on — then I can be pretty confident that, on the whole, the stock market will show a steady increase over the next decade or three.
Another difference between investment and speculation is your time horizon. Investors are in it for the long haul; speculator are hope to make money off of short-term market fluctuations.
The Problem with Bitcoin
All of this leads me back to the folks I know who are so eager to speculate right now. I have several friends who are riding the Bitcoin bandwagon, and they think they're savvy investors. They're not. What they're doing is speculating, the same as I used to do. They're taking on high risk in the hopes of huge gains in the short term. This isn't investing; it's speculation.
If you want to speculate in Bitcoin, go for it. But don't delude yourself that what you're doing is investing.
I don't remember the exact date I first heard about Bitcoin, but I remember the place. I'd recently started doing Crossfit, and I was using a foam roller to work out a kink in my quads on the floor of the gym. My buddy Dan was next to me, and he asked me what I thought about Bitcoin. (Dan knew I wrote about personal finance, so he always had money questions for me.)
I told him I didn't know anything about Bitcoin, so he gave me a primer. If you need an explanation or refresher, here's a Khan Academy video that provides an overview:
Based on the location and the people present, this must have been in early January 2012, when Bitcoin had reached a then-record high of $7.
“Would you buy Bitcoin?” Dan asked as we put away our foam rollers and moved to the weight room.
“I don't know,” I said. “I'd have to learn more about it. I have a policy of never putting money into something I don't understand.”
After that conversation, I did some reading about cryptocurrency. I decided I liked the idea, but as a store of value, not as an investment. To me, that's a very big difference. I like the idea of a decentralized currency that's not controlled by any one government. That's kind of cool. But in 2012, I didn't like the idea of sinking money into a Bitcoin as an investment.
In the past 5+ years, the value of Bitcoin has skyrocketed. Recently, it's been trading at $7000! In other words, the value of Bitcoin has multiplied one thousand times since my conversation with Dan on the floor of the gym.
If I had moved all of my invested capital from index funds to Bitcoin in early 2012, today I would be a billionaire. If I had invested even just $1000 then, that $1000 would now be worth $1,000,000.
Did I screw up? I don't think so. And given the same choice again, I'd do nothing differently.
That's because I believe strongly that nobody is actually “investing” in Bitcoin; they're merely speculating. So far, that speculation has paid off. And maybe it will continue to pay off. But I believe it won't go on forever.
Be Fearful When Others Are Greedy
Another one of Warren Buffett's most famous quotes is appropriate to this situation: “Be fearful when others are greedy and greedy only when others are fearful.“
Right now, the folks pouring money into Bitcoin (and other cryptocurrencies) are greedy. For that reason, I'm fearful. This looks exactly like so many situations I've seen in the past, including my own past “investment” mistakes. While I'm fine with the underlying concept of cryptocurrency, there's no way in hell I'd put my own money into it now. Not a chance. The risk is just too high.
What if you want to put money into Bitcoin? Fine. Go ahead. But don't you dare think of it as an investment, because it's not. It's just like playing blackjack at the casino.
And if you do want to put money into cryptocurrency, please do me a favor: Only use money that you can afford to lose.
- If you're struggling to make ends meet, steer clear.
- If you're in debt, steer clear.
- If you haven't funded your retirement accounts for the year, steer clear.
If you don't have your financial shit together and absolutely must make the leap, then limit yourself to at most sinking five percent of your “savings” into Bitcoin. Any more is gambling with your future.
But if you're debt-free, have some savings, and have set aside money for retirement, then take the risk if you want to. In my mind, it's no different than putting your money into the Palm IPO like I did. (And I think the results are likely to be the same.)
Right now, it feels to me as if we're in a Bitcoin bubble. Maybe I'm wrong, but that's what it feels like. It feels just the same as the housing market in 2007, as the stock market in early 2000. And here's the thing: There's no risk in not putting money into Bitcoin. If its value jumps to $70,000, then all I've lost is some opportunity cost. I'm fine with that.
For further reading, here's a great article that describes some of the factors that influence the volatility of Bitcoin and other cryptocurrencies.
I'm going to state this explicitly because otherwise the comments are likely to get derailed. I am not anti-Bitcoin. I kind of like the concept of cryptocurrencies, but as currencies, not as investment vehicles. What I'm worried about here is Bitcoin speculation.
This is the same concern I feel when I read about anyone who tries to get rich quickly. In 2006, for example, I was writing about folks like Casey Serin, the young man who thought he could get rich buying and flipping houses. Instead, he crashed and burned. I'm afraid the same thing is going to happen to many folks riding the Bitcoin bandwagon.