When are you Speculating vs. Investing?

Question

This might be an interesting topic born from another thread.

When is buying or operating in real estate a speculative venture and when are you investing? How do you define speculating and investing, what's the difference?

Kobus De Villiers · Answer

I look at speculation and investing based on the basic principle that is commonly used in stock and other forms of investment. In stock the difference between the investor and the speculator is that the speculator buys because everybody else is buying and he has the notion that the stock will increase and provide a profit. Typically buys based on the latest hot stock tip that he received via email.

On the other hand the investor does analysis (either fundamental or technical) and based on those conditions purchase because his analysis determined that it is the best option given his risk tolerance and other variables.

If we appy that to real estate then the difference would be similar. The investor start by doing analysis and that analysis points him to a specific property that he believes would satisfy his investment model. The speculator merely picks a place to buy without doing analysis and hoping that he will be able to sell for a profit in the future.

The investor has a specific goal or strategy in mind and with this goal identified a suitable property. The speculator sees a property at a low price and just because it is now $50/sq ft and previously was valued at $100/sq ft buys hoping that he will be able to turn a prifit like everybody else since it seems like the right thing to do.

Account Closed · Answer

An important aspect here though is also the margin of safety involved.  I could allow the fear of being struck by lighting prevent me from venturing out in a storm.  I can't control lighting and I could be struck down.

Though you might lack control of some issues.  You can have a high margin of safety when you know the market, have knowledge of the investment type, have a good understanding of economic and political issues of the area, have insights that others may not have.

My point would be that for someone to call an activity speculation without more understanding of the analysis and assessment that an investor did is comical.  A news writer that says investing in real estate is pure speculation always brings a smile to my face because in the back of my mind I know full well they don't understand the investment.

Sound investing and speculation are on to ends of the spectrum.  Someone that doesn't know much about an investment may well be speculating even when others would be said to be investing.

Bryan Hancock · Answer

I certainly agree that there is a spectrum and those with the ability to manage things well control their risk more.

HOWEVER, there are many things in life that CANNOT be controlled.  Systemic risks are uncontrollable by definition and thus any investment is still "betting" to a certain extent.

Interest rates are totally unpredictable.  The government passing the Tax Reform Act of 1986 is totally unpredictable.  There are many more variables that I can cite that cannot be controlled by and investor.  Any position they take is somewhat betting on what will happen with these uncontrollable variables.

Account Closed · Answer

In financial terms speculating and investing have very specific definitions.  Here is a good definition for these two activities:

http://en.wikipedia.org/wiki/Speculation

It fascinates me when Realtors call RE investors speculators.  It makes me smile when I hear investors say that one style of investing is speculative.

I have to agree with Bill here.  A newbie without the fundamental skills needed may will be speculating.  While another that understands the market, the elements of the investment, how to control the elements, how to exit the investment can have a wide margin of safety and would not be speculating.

Mitch Kronowit · Answer

If you made money, you invested. If you lost money, you speculated!   :mrgreen:

Ok, seriously, here's my take.

There are basically 4 ways of growing your money: saving, investing, speculating, and gambling. The order of these are no accident. I believe most would agree they lie in order of increasing risk and payoff/reward. The differences in each are subtle, but important.

1. Saving - Maximum security, minimal reward. This could actually include stuffing your cash in a mattress during a deflationary period because the buying power of your hoard increases, however, for most intents and purposes, saving is socking your dough away in an institution, often insured, with a guaranteed return, usually very small, but you can literally bank on it. These are your savings (time) accounts and certificates of deposits.

2. Investing - My definition (forged from others) is putting your money where you're sure to get back more than you put in, but the return is variable, or unknown, and is generally higher than saving because of the added risk. Dividend paying stocks, bonds, cash-flowing real estate, and making private loans are all examples of investing. You can also say purchasing a piece of equipment for your business that is going to increase productivity ($$$) is also a form of investment.

3. Speculating - I believe speculating is investing without a guaranteed return on your money. But it's a little bit better than gambling because you can take certain steps to hedge your bet. You can exercise limited control over the outcome and/or equip yourself with some information that steers your investment.

Drilling for oil comes to mind. If you just started boring holes in the Earth in an uneducated hap-hazard manner expecting to strike it rich, you're gambling. But you're speculating if you hire a geologist who can help find a good drilling site. There's still no guarantee of striking oil, but your odds are much better than throwing lawn darts into the air and drilling where they fall. "Investing" in start-ups, rare coins, art collections, growth stocks, etc. are other examples of speculating. You could say speculating is a form of controlled "hope".

I would lump trading and dealing, such as flipping homes or simply running a retail business, into the speculating category as well, because you're relying on finding a buyer for your products. You're putting up money today for something in hopes that you'll sell it for more at a later date. There's no guarantee that you will, only a calculated risk. "Investing" in real estate simply for appreciation can be considered speculation as well because a return on your money isn't guaranteed.

But what if your property (or stock, art/coin collection, etc.) does go up in value? Are you still speculating if you hold on to it or are you now investing?  :wink:

4. Gambling - Maximum reward, minimal security. Simply nothing more than the luck of the draw. You have no control or influence at all over the outcome. Every single bet is just a guess because whatever transpired in the past has absolutely no bearing on the future. Yeah, you can argue a good card counter has an edge in blackjack, but otherwise, gambling is driven by randomness, not knowledge, research, collaboration, etc.

I always chuckle when I see those roulette wheels that post the last 10 or 20 numbers that came up. Like any of that has anything to do with the next spin. Oh well, there's always those that look for patterns in chaotic functions. That's how those casinos in Las Vegas and Atlantic City get so wealthy.

Bill Gulley · Answer

J.T. is an accomplished persuasive writer. Just as any good politician will begin by setting the parameters with assumptions that are not totally accurate, J.T. began with his position. His relationship of gambling and investing is an old one, but in economic, financial, statistical or let's say from a scientifc business basis, the statement is not a true.

While J.T. addressed the issues of risk, which is inherent to speculation and investing in real estate, it fails to address the difference between speculation and investing.

Let me begin by going way back to the first chapter of Economics 101, after the professor introduces themselves and begins talking about the general introductions to the topic, the student will be first exposed to the four basic functions of economics:

Land, Labor, Capital and Entrepreneurship.

These four functions of our economy are the ingredients necessary, to some extent, for every business transaction made by mankind.

Success in any business means mastering the manipulation or use of these four elements. That really holds true in real estate.

Generally, in real estate, land is obviously the dirt we attempt to control (note I did not say own). Labor is the construction of improvemets to the mopping of the floors. Capital is the money to facilitate the control and use the property and the Entrepreneurship are the skills of management, talents and imagination required to match or blend the other functions together to make an economic profit.

The aspects of entrepreneurship is the only basic function that can generate an economic profit alone or by itself. All other functions require a combination other functions or must be used in conjunction with entrepreneurship to produce an economic profit. You can't put money in a CD without implementing some small degree of management in selecting the CD, filing out the account information and making the deposit.

Keeping this in mind, consider the skills required to any real estate transaction and in blending these economic functions. In every case or transaction some degree of management skills, negotiating and analysis will be required.

(Sorry I went so long around the bush, but we are here now)

The difference between investing and speculation has more to do with the degree of control or management over the proposed transaction, than gambling by chance.

Assume I am entering into a purchase to sell a property that is very unique, like a burm home with only wood heat and no air conditioning and it is located in northern Missouri in a rural area on 10 acres.

Now, let's assume that the newest memeber of BP is also interested in this same property. We will call him Newbie. The property is for sale for 100K and the seller needs a down payment and money to buy another home with a real furnace. Both Newbie and I have identical capital, but not sufficent to pay cash. Without making this a structured deal analysis or strategy operation, let's get to the skils and managements side of the deal.

Both Newbie and I intend to buy and sell the property for a profit. In short, let me say that, the property is a great deal and for me, I would consider this an investing transaction. Knowing the putfalls of the property (that property will not qualify for a conventional loan), I will buy it on terms with the seller and sell it with an installment contract wrapping my purchase.

Now comes Newbie, together with his wife. They think it's really a cool house and a great deal.  They have noidea how to structre the deal to buy it, much less sell it.

While my previous "rantings" are expected to come together later on, does anyone see that the Newbies could be speculating?

Further, let's say the seller heard my proposal and explained the deal to them, but at a higher price. The seller told them they could live there for some time and allow it to appreciateand make even more on the home later on. They liked the house. Would their buying the property, living in it and attempting to sell it later on be speculative, or is it an investment?

Bryan Hancock · Answer

Nice thread split-out Bill!  I think you may be interested in reading JTR's thoughts on the matter here:

The nature of investment by John T. Reed

Thought-provoking to say the least.

Bryan Hancock · Answer

Margin of safety is nice to have, but it only insulates you from downside.  If interest rates move really far or other uncontrollable things happen your investment will still be impacted.

The terms betting, speculating, investing, etc. are really kind of in the eye of the beholder I guess.

Bill Gulley · Answer

The question is; is the risk associated with the investment acceptable, the risk-reward acceptable.....you could get hit by a Mac truck on the way to the bank to open that CD too! But it doesn't alter the obvious difference between investing and speculating with the risks being similar.

But, IMO, Brian, you are thinking down the same path as I am. Assume the same risk is involved, maybe not the same risks, but risks with similar impact. You hit on it.....controlling the deal.

With a higher degree of expertise in a particular deal, as Charles mentioned, IMO what is speculation for one may not be for another.

Kobus, I agree with your opinions as well to some extent, but the analysis performed may provide more information or a better way to manage risks. Analysis alone will not allow you to control the outcome.

Here was my point: The gas company could decide to pull out, for what ever reason. I can not control what that company decides to do. When I forego the bird in hand, so to speak, and hold out for the sale of the easement, that is pure speculation. No matter what I do, how much due diligence I perform, Iprobably will not be in a position to motivate the gas company to follow through. I'm risking the loss of by sale to my buyer and actually reducing the economic benefits. My "opportunity costs" just went up in relation to the possible profits of cutting both deals.

The reason I went through all the economic factors was to explain the ability to utilize any of those factors in any transaction, but the most important being the ability to manage the outcome.

If the anticipated profit in any transaction can not be controlled to an ascertainable level to effect the end result, you are speculating. If you can controll the outcome to an acceptable degree of confidence, you are investing.

There are always aspects of investing or life that can not be controlled, the key, IMO, is the ability to obtain the expected result. And that will boil down to knowledge.

For those thinking of this in terms of stock trading or futures, do speculators really speculate or is there a manipulation of the market? When billion dollar account managers can use computer programs to execute trades in micro seconds, (took some knowledge to put that together!) and at the end of the day, more often than not, the account makes money, is that really speculating? I don't think so.

Bryan Hancock · Answer

To a certain extent any investment contains items you cannot control.  Some projects can obviously be influenced more than others, but there is still an element of "betting" on any project because of these risks beyond your control.

A detailed analysis, by definition, cannot changes things that you cannot control.  You have no control over whether or not interest rates go up by 3% over the holding period of your investment.  You also cannot control what Congress does with the tax code or how much money The Fed puts in the economy.

That is the nature of investing as is described in JTR's piece above.  Again....I agree that there is a spectrum, but I don't think that people can avoid speculating to a degree on any "investment" (bet?) they make.

When are you Speculating vs. Investing?

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