What is the difference between investing and speculation?

Investing, in theory, is a very simple concept. You buy an asset for less than you think that it’s worth or its intrinsic value with the expectation that it will return to its fair value over time. In this way you can make a profit from your investment. Whilst the concept is very simple, in practice it requires a lot of judgement, analysis and careful consideration.

How do you determine the intrinsic value of an asset? With some assets, like equities, bonds and real estate, you can use their income generating potential to come to an estimated value. 

Properties can be rented and therefore you get an idea of the rental yield. Bonds generate interest income. Stocks declare earnings and pay out dividends and therefore can be valued on the basis of the underlying strength of the business. These are therefore called productive assets. Every type of productive asset has its own unique pros and cons, risks and rewards – but fundamentally you can arrive at an intrinsic value for them based on their underlying cash flows.

Speculation on the other hand is when you buy something with the expectation that someone will pay more for it in the future. When you speculate on an asset, the intrinsic value of it does not come into the picture – typically speculative assets are non-productive and don’t generate cash flows.

It might surprise you, but gold is one example of a non-productive asset. To be fair though, gold has centuries of history where we collectively as a society have assigned a certain value to it and therefore it can be seen as a store of value. A gold coin today will be a gold coin 100 years from now – and therefore at best gold can help keep up with inflation, it will not produce any additional income for you.

This doesn’t mean that gold plays no role in an investment portfolio or even that it should be seen as a useless asset.  But it is important to understand why typically gold has a lower allocation in portfolios when compared to other asset classes – without any cash flows it is very hard to fundamentally value the metal and say whether it is above or below its fair value. 

When you are looking at buying any asset, it is important to keep these concepts in mind. Can you come to an intrinsic value? Are you investing or speculating?