Are you investing or speculating? (The Real Definition of Investing)
Here’s my definition for what investing is:
Investing, in the financial sense of the word, is the deployment of capital (usually money) into the purchase of shares, purchase of assets, development of commercial ventures, or other financial schemes in order to obtain a return on that deployed capital with a reasonable expectation (grounded in some sort of reasonable analysis) that the risk-adjusted or expected return is positive.
That’s a long and somewhat fluffy definition, but any definition that would cover the broad range of activities that could properly be classified as investing will be somewhat fluffy. Let’s break down the main elements of that definition and discuss them briefly.
… the deployment of capital … : This means you use some sort of capital (usually money) to invest. Without using or committing capital, you’re not really investing. You can invest your time and energy into things, but that wouldn’t qualify as financial investing. You must deploy capital in some way for your activity to properly be called investing in the financial sense of the word.
… or other financial schemes … : Investing requires the deployment of capital in a specific way. It requires that the capital be used to either purchase shares of a firm (the firm can be publicly traded or privately held), purchase assets (purchasing gold, Bitcoin, fine rugs, or fine art might qualify as asset purchases), develop commercial ventures (start a business or develop a new office building), or to pursue some other type of financial scheme. It’s not easy to make an exhaustive list of the other possible financial schemes because there are many possibilities. For example, a properly documented and agreed upon private loan to an acquaintance can qualify as an investment. The purchase of various derivatives products might qualify as an investment as well. Even the purchase of rare grapes for the purpose of creating a unique wine could qualify as an investment. It’s impossible to describe every possibility here, of course, but this should give you a general understanding of what I mean by a financial scheme.
… in order to obtain a return … : Investing requires that the deployment of the funds is done to obtain some financial return. If no return is expected or desired, then the deployment of capital is more like a donation or a purchase depending on the circumstances. Financial investing requires that it is done for the purposes of growing your capital base by receiving a return on the invested funds.
… reasonable expectation … : Investing requires that we are reasonable in our expectations of the financial return from our endeavor. If we are unreasonable or foolish, it’s not investing in my opinion. A reasonable person using reasonable analysis techniques (they don’t have to be complicated, just sound and reasonable) should be able to agree that a positive return is possible. This means that if unfounded, biased, or inappropriate techniques of analysis are used in order to determine what the potential return is (either expected return), it is not investing in the proper sense of the word. For example, using deeply incorrect assumptions that you know don’t make sense to calculate your expected return wouldn’t hold up to this standard. You wouldn’t be investing here, but would instead be fooling yourself and possibly speculating. Additionally, not dong any analysis whatsoever before deploying capital would preclude the activity from being called investing. The analysis doesn’t have to be complicated (although deeper analysis is likely better), but some sort of thought must be given to what is occurring if we are to call the activity investing.
… that the risk-adjusted or expected return is positive. : This point speaks to how we calculate the return. We state that the return has to be positive, but we need to know how to calculate the return. In calculating the possible return, a more sophisticated investor should adjust for risk, calculating what is called the risk-adjusted return or the expected return (these two names can generally be used interchangeably in a non-academic or unsophisticated setting). There are complicated mathematical formulae for calculating risk-adjusted numbers, but what is meant here is something more basic: the return you expect to get should from your investment should be the adjusted for risk, with less probable outcomes discounted more intensely. In other words, the return can be thought of as a weighted average of the possible returns, each return weighted by its probability of occurrence. Going further, this means that investing requires that the expected return is positive. That expected return might never occur, but at the outset (when we deploy the capital) the expected return should be positive. No rational individual would deploy capital into a financial scheme that has a negative expected return.
What Investing Is Not
Investing, in the financial sense of the word, can be distinguished from other uses of capital or energy. Investing is not:
Work: If you expend energy but never deploy capital, it’s more like a job. You are getting paid for your labor and for your skills.
Saving: Putting away money is not the same as investing. Investing requires the deployment of capital. Saving money (whether it be in a bank account or under your mattress) is the accumulation of capital, but the capital is never at risk in any sort of financial scheme and the only return on the capital that could be obtained is compensation for the time value of money (eg. interest you get at the bank).
Speculation: This is a broad category, but it can cover many things that require the deployment of capital that don’t provide a reasonably expected positive risk-adjusted or expected return. Gambling at the roulette or blackjack table is speculation because the risk-adjusted or expected return is actually negative. Buying things that are not assets in hopes to resell them later can be called speculation in some cases. Even purchasing real estate can be called speculation in certain cases (eg. foolish and naive purchasing prior the Great Recession in hopes of reselling at a later date). Speculation occurs when a would-be investor is deploying capital in a way that is not reasonably prudent. This doesn’t mean that if the venture is very risky it should be classified as speculation. A financial venture or scheme could be extremely risky and could still be classified as an investment so long as the risk-adjusted or expected return is positive. For example, a venture with a 99.99% chance of a total loss of the principal and a 0.01% of success could be classified as an investment if the reward for the 0.01% chance is great enough to offset the very likely total loss. It would be an extremely risky investment, but it could be an investment nonetheless. Speculation occurs when there shouldn’t be a reasonable expectation of success based on some sort of reasonable analysis.
Keep the Definition of Investing in Mind to Avoid Foolish Bets
In conclusion, we see that investing is a specific type of deployment of capital and is distinguished from work, saving, and speculation. Keeping the definition of investing in mind could help us differentiate between investing and speculation by applying the definition in a disciplined way before we deploy our capital. Investing is a fundamental part of individual wealth-building and it allows for a society to grow and prosper, but it should be done wisely and carefully so as to make sure that foolish bets are not being taken.