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.

[J.D., counting his money]

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.)

Tally, taking herself for a walk

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.

Bitcoin is NOT an investment

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.

Final Note

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.

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Accidental Fire
Accidental Fire
2 years ago

Great use of the rent-is-too-high-guy meme! You’re right it’s speculating and gambling. I great friend of mine asked me a while ago it I’m into crypto currencies because she said her brother is making a killing. I looked into it and made my “no way” decision. I tend to think Murphy’s Law applies more to me than others sometimes. My best friend is the opposite – he can illegally park for an entire day in the city and not get a ticket. If I try it I’d have a ticket in 10 minutes. So if they want the run-up of… Read more »

Lady Dividend
Lady Dividend
2 years ago

Great contrarian post! I agree that currencies are not for speculation. Plus I personally don’t know enough about this to put my money there. There are too many unknowns.

Anne
Anne
2 years ago

The dog walk analogy was so clear at least for me due to having two dogs. A helpful way to visualize it.

dh
dh
2 years ago

All my money goes into VTSMX, but when I get a wild hair once in awhile, I’ll simply buy a $2 lottery ticket. It’s dumb, sure, but probably less dumb than Bitcoin.

Coopersmith
Coopersmith
2 years ago

Very good post. I am glad you are back and offering some good insightful posts. When I was young I was more speculative but in a good way with good paying dividend stocks and made some decent money but also was on a roller coaster of ups and down with those stocks. Now that I am nearing retirement I am more cautious. An example was I started investing in P2P lending and realized it was not for me.I was only in for 1 1/2 years and only $2500 before I realized that I did not like it. Too much volatility… Read more »

JH
JH
2 years ago

The thing with Bitcoin that I think is most concerning is that I don’t know ANYONE using it as an actual spendable currency, haha. Everyone I know that is excited about it is excited about it for the purposes of “investing.” I have about half of my money in index funds and the other half in individual stocks. My individual stocks are typically in companies whose products I use on a daily or weekly basis (Apple, Amazon, Google, Netflix, and so forth). Those have outpaced the market over the past four years or so that I’ve been in them but… Read more »

Rh
Rh
2 years ago

Can you short Bitcoin??

jon
jon
2 years ago

I put about $300 in Bitcoin when it was at $700. I did it so I could use purse.io which gives me a 15% discount on Amazon purchases (maybe about 12% after all the fees). I didn’t spend all the money. So, I’ve been pretty much purchasing from Amazon for free ever since. I don’t buy a lot on Amazon. Maybe every other month I’ll make maybe $100 worth of purchases on it. I’m tempted to put more money into it (like 5% of my retirement savings). But I keep thinking the same thing you posted here. It’s speculation and… Read more »

M
M
2 years ago

The Tech Bubble in 2000 burst at a market cap of $2.948 Trillion dollars and was essentially limited to the US market. The cryptocurrency market cap is currently at about $200 Billion dollars and is global in nature. The analogy doesn’t really work here. And from the tech bubble emerged several amazing companies, Amazon, Microsoft – we even have a successful Pets.com now, in Chewy. I think you overestimate how many speculators there are (there certainly are a fair share) and underestimate how many smart, engaged people are interested and thoughtfully investing (yes investing). Also, what if the bitcoin bubble… Read more »

Steven
Steven
2 years ago

I’m new to all this…where exactly do you buy BitCoin?
Many thanks!

JoeHx
JoeHx
2 years ago
Reply to  Steven

Coinbase (https://www.coinbase.com/) is where most people buy it. I think they only let people from certain jurisdictions have an account (e.g. US).

JoeHx
JoeHx
2 years ago

I’m having fun riding the bitcoin and cryptocurrency wave, but I’m doing it in a manner that I’m prepared to lose 100% of my investment (sorry.. my speculation?).

Speculation is why it’s gotten so high. More people are buying, expecting the price to go up, which drives the price up. Self-fulfilling prophecy, I suppose? But when people decide it’s time to jump ship, the opposite will happen.

SC
SC
2 years ago

I think it is also true that people are speculating in their home, not investing. I for one, very unfortunately, am going to lose a lot on the home we are trying to sell.

Kevin
Kevin
2 years ago
Reply to  SC

You are very right and you have been right for a while. Many reasons the 2008 retraction was so rapid and awful was because people were speculating on home prices without the ability to hold them for more than 6 months.

Which means that if they couldn’t sell for the price they “want” they would have to liquidate which is what caused the real estate collapses in places like Florida and Vegas.

Explosive value loss is always made worse when speculation is more than a marginal fraction of trading.

Brian Burgess
Brian Burgess
1 year ago

Nice post. Since you wrote this in November 2017 we saw a huge pump in Bitcoin’s price through December 2017 followed by a protracted bear market during the whole of 2018. Many people who bought during December 2017 would have seen huge paper losses by now and if thry sold during the bear market would have lost a lot of money. However I do think your final point that “there is no risk in NOT putting money in bitcoin” (except opportunity cost) sounds a bit like ‘sour grapes.’ (as does the entire article really.) Whilst it is true of bitcoin… Read more »

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