It’s hard to imagine that just a year ago, we were in some of the darkest days in a generation, unclear about what the direction of our health and wealth would be because of the pandemic. Fast forward a year later and the stock market is hitting record highs, a bitcoin is worth more than the median income in the U.S. and non-fungible tokens (NFTs) are making the possibility of selling artwork more accessible—and lucrative—for digital artists. To a cynical observer (in this case, me), there seems to be all sorts of feverish and, frankly, concerning, activity happening between people and their money. I see this kind of activity as a red flag for a distinction that everyone needs to know about: speculation vs. investing. 

What’s Happening Right Now

Let’s start with some modern day context. People are talking about buying and selling all sorts of things they’ve never mentioned before. Suddenly, cryptocurrencies are a sure-fire investment and will eventually take over existing currencies (it most likely won’t). Trendy investments like digital art and baseball cards are gaining ground, and others like Special Purpose Acquisition Companies (SPACs), which have been around since the 1990s, have become a hot market. People are rushing to pour money into these assets to the point where it feels like mania. 

With all this going on, I can’t help but think about how we handle our own investments during a vulnerable time. Right now, particularly with the rollercoaster of the pandemic under us, it’s tempting to believe when someone else says they just made a fortune off of a shiny new market — and that it was easy, no less! But, like my dad used to say, “If it’s too good to be true, it probably is.”

The Difference Between Speculation vs. Investing

What people are doing when they invest in crypto, SPACs, baseball cards and the like is called speculating. When you speculate, you are, to use another word, gambling on the direction of the price of something based purely on what you think someone else will pay for it. Buying cryptocurrency because the value will go to the moon is not based on some fundamental value, but a guess at what other people will pay. 

To me, one of the most dangerous (and costly) points of view to take is to make a bet on something that may not have much fundamental value based on what you think someone will pay for it later, rather than a bet on something that will produce earnings, cash flow, and returns. The value of a cryptocurrency is what someone thinks what it’s worth in a day, a month, or a year. The value of Apple is the value of what its cash flows and earnings are over the foreseeable future. Yes, people can ascribe value to those things, but the latter example is more tangible. 

As a note, I’m not knocking cryptocurrencies or other assets like these. They do hold some place in our global system, but, rather, I’m talking about the frenzied activity that is taking place surrounding them and how that can be damaging (more on that in a minute).

So, then what is an investment? 

By contrast, an investment is something that you think will produce a return for you over time. Let’s use the example of a stock index fund. When you purchase an investment in this type of fund, you are purchasing an investment in the thousands of companies that produce earnings and cash flow year in and year out. The value is based on those earnings and how the business grows and earns money. By contrast, some things like cryptocurrencies or baseball cards only hold value to the extent others view them as valuable. 

Getting a return on speculative activity isn’t a sure-fire thing because, much of the time, speculation is more about guessing what something will be “worth” (if anything) in a short amount of time, e.g. I’m buying bitcoin because I think it will be worth $70k instead of $50k in the short term. Much of the time, speculators will lose money on their investment because it’s not being based on data, reason, risk management, and a long term plan. 

Read More: Creating A Long Term Investment Plan: Tune Out The Noise!

Why Do People Speculate Instead of Invest? 

If speculation is unreliable in return on investment, then why do so many people do it? Are people interested in cryptocurrencies, digital art, or SPACs because they think they will make valuable investments, or are they just betting on the price at which these things will sell? Are they thinking they can make some easy money? 

First, another quote, this time from Edwin Lefèvre, an American journalist who wrote about Wall Street and (rather scathingly) about speculation. Lefèvre wrote, “ “Easy money” means only one thing when it means money that has come easy: It means money goes even more easily than it came.”

It seems like Edwin and my dad saw things pretty similarly. 

Speculation has been around for centuries. In fact, the first recorded speculative bubble was in the Netherlands in the 1600s when “tulipmania” drove up the price of tulip bulbs. There were some rare tulip bulbs that were priced at six times more than the average person’s annual salary at the time. Then, prices plummeted and the people who had bought into this scheme lost a lot of money, quickly. That’s the cost of speculation. 

There hasn’t been a lot of research done on speculation, but the Journal of Behavioral Addictions looked at the relationship between investing, speculation, and gambling through a comprehensive analysis of their similarities and differences, and analyzed existing research. While there are definite ties between speculation and gambling, many differences have to do with the type of speculation, the turnaround time of return, and the skill level. Meanwhile, the same personality attributes exist in both gambling and financial trading: risk-taking and sensation-seeking. 

I’m not here to say the fundamental merits of any of these assets is good, bad, or otherwise, or that participating in speculative activity is an indicator of a bigger problem. But I am using this as a gut check for people: Are you speculating or are you investing? I want to make sure you are clear on it, particularly as more opportunities to speculate gain traction with the general public. 

If you are walking into the arena of speculation, here are some things to keep in mind:

Resist the urge! I’ve seen it time and time again: nothing bothers people more than to find out their friends are making more money than them on some hot investment. They want in! I don’t blame you. Seriously, who doesn’t want a stack of cash (or crypto) dropped in their lap? That being said, I encourage you to look the other way, and stick to your financial plan. You’re more likely to get to where you want to go by following the steadier (albeit slower) pathway to building wealth. 

Change your approach: Think of this as play money, not some investment that is going to be the keys to financial freedom. It’s a lottery ticket—the odds of you winning are slimmer than you imagine. 

If you can’t resist, keep it small! If you can’t resist buying into the latest thing, do it only with a small amount of money. If you want to buy some bitcoin, buy only 1% of your net worth, not 10%. That way, if the price of what you buy falls by 50%, it’s not going to hurt as much because you’ve taken a minimal amount of risk. 

Read More: What is an Asset Allocation?

If you’ve made a lot of money? Great! Protect yourself by taking some of your winnings off the table, or sell some of your new asset to avoid investing further into it. Then you can play with “house money,” as the saying goes. 

When fad-driven markets appear, the best thing to do is to stick to your financial plan, and don’t take more risk than you normally would. It may feel really predictable, especially with the allure of new, intriguing assets promising fast cash, but in the long run, you will be better off (and more sane!) if you steer clear of these money traps.

Interested in receiving this content in our monthly newsletter? Sign up here!