Speculation vs. Gambling
By: Samuel Acquah
Tags: Investing, Finance, Forex

Speculation vs. Gambling

What is the Difference Between Speculation and Gambling?

The futures industry we know today, has in the past struggled with the reputation that it was nothing more than a financial casino for gamblers. Nothing more than a speculative endeavor undertaking by hordes of misguided traders with false hopes of obtaining large fortunes. It took pains over the decades to distinguish itself from pure gambling (and despite its continued growth in the alternative investment market space, it still struggles to gain acceptance as a viable alternative investment option in more conservative financial circles). The over-the-counter foreign exchange market contends with a similar perception today. Having spent nearly a decade trading markets ranging from traditional stocks and bonds to less conventional markets like futures, options, and forex, I find this view by its many skeptics, a number of them who have no real investment experience in this realm, to be particularly misguided. Although some superficial similarities do exist between the speculative nature of futures, forex, and gambling — an in depth look at the two concepts — reveals not only the principle differences between them, but also the misconception the general public holds about all investments.

Let’s begin by first defining the ways in which gambling and speculation are similar. Gambling by definition, is to take a risky action with the hope of achieving a desired result (e.g., playing slots at a casino), or simply put, it’s the idea of staking something of value on a contingency. Speculation is the act of trading in an asset, or conducting a financial transaction, that has a significant risk of loss, in expectation of a substantial gain. In essence, the underlying concept in common between the two terms is the potential for gain through the assumption of risk. But this is also where the similarity ends. While it is often confused with gambling, the primary difference is that speculation is generally tantamount to taking a calculated risk and is not dependent on pure chance, whereas gambling depends on totally random outcomes or chance. What do I mean by this? To be clear, an investment in any form, regardless of the asset or market, fits the shared common definition of gambling and speculation; and thus carries some form of risk, with a potential for gain. If this premise were not true, why would anyone invest at all? No investment is without risk, and there is always a trade-off made between the possible returns and the amount of risk one is willing to assume, in order to reach a financial goal. What further distinguishes the two concepts depends on a number of factors; such as the nature of the asset, the duration of the holding period, the amount of leverage, the trading strategy, and the risk management employed. If you’re confused at this point, don’t worry, we shall soon delve deeper into the matter.

To fully grasp the concept that all investments are speculative in some form, it is important to first understand and appreciate the concept of risk, and how it exists in all forms of investing. Risk, in the simplest terms, is the idea that an investment’s actual return could be different than expected. It also includes the possibility of loss of most or all of one’s investment. Risk can also emerge in multiple forms across different assets and it is imperative for the sophisticated investor to understand the different ways it does so, to make any investment speculative.

Risk: How it Affects all Investment Outcomes

There is a seemingly infinite number of risks one can identify as a reason to avoid investing in any asset, but for the sake of time (and writing space), we shall only discuss the most prominent forms and how they apply to some of the investments previously mentioned. Risk in investing can be present in the form of: interest rate risk, credit risk, business risk, inflationary risk, liquidity risk, and ultimately, market risk. Let us further explore it by starting with interest rate risk.

Interest Rate Risk

Interest rate risk is the possibility that a fixed-rate debt instrument (e.g., a bond) will decline in value as a result of an increase in interest rates. Whenever investors buy securities that offer a fixed rate of return, they are exposing themselves to interest rate risk. This is due to the fact that another investor will pay less for a bond instrument paying 4% interest if the current going market rate is 6%. Therefore, the amount one paid for the bond would have to decrease to compensate for the lower coupon rate (or interest payment).

Credit Risk

This type of risk refers to the possibility that a particular issuer of a bond will not be able to make the expected interest rate payments and/or principal repayment on a bond. Typically, the higher the credit risk, the higher the interest rate on the bond.

Business Risk

Business risk is the type of risk associated with a specific security such as a stock. It is also known as unsystematic risk, which refers to the risk associated with a specific issuer of a security. Generally speaking, all businesses in the same industry have similar types of business risk. Business risk refers to the possibility that the issuer of a stock or a bond may go bankrupt or be unable to pay the interest or principal it owes in the case of bonds. A common way to avoid this risk is to diversify — namely, to buy mutual funds and exchange traded funds (which hold the securities of many companies), or to seek investments in alternative markets. But even then, one is vulnerable to another type of risk we shall discuss later.

Inflationary Risk

Also known as purchasing power risk, is the chance that the value of an asset or income will be eroded as inflation shrinks the value of a country’s currency. Put another way, it is the risk that future inflation will cause the purchasing power of cash flow from an investment to decline. The best way to fight this type of risk is through appreciable investments (e.g., stocks, bonds, forex), which have a return component with the potential to stay ahead of inflation over the long term. Investors who attempt to play it safe by avoiding these investments, leave themselves vulnerable to this type of risk. Consider that the average rate of inflation in the United States based on the Consumer Price Index (CPI) from 1925 through 2014, has a long-term average of inflation rate of 3.0% annually, according to Bankrate.com. This means if one was to simply hold on to $1,000 without investing it in any form, that same $1000 would only have a purchasing power of $744 a decade later, losing nearly 30% of its purchasing power.

Liquidity Risk

Liquidity risk is the possibility that an investor may not be able to buy or sell an investment when desired in sufficient quantities because opportunities are limited. A prime example of liquidity risk is selling real estate. In most cases, it is difficult to sell a property at any given moment should the need arise, unlike government securities or blue chip stocks. This type of risk is especially common in markets where the financial instrument being bought and sold is not standardized (or uniform). Every property in the real estate market is unique, and thus may only appeal to a particular segment of buyers in the market. This reality makes the process of matching a buyer with a seller much more difficult than the stock market, where every share of a common stock is similar to the next and easily transferable.

Market Risk

Market risk, also called systematic risk, is a risk that affects all securities in the same manner, regardless of business or industry type. In other words, it is caused by some factor that cannot be controlled by diversification. It is a risk inherent to an entire market or an entire market segment. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the right asset allocation strategy. For example, a portion of assets in bonds versus stocks can mitigate systematic risk because an interest rate shift that makes bonds less valuable will tend to make stocks more valuable, and vice versa, thus limiting the overall change in a portfolio’s value from systematic changes. Interest rate changes, inflation, recessions and wars all represent sources of systematic risk because they affect the entire market. It therefore important to note that systematic risk underlies all other investment risks previously mentioned.

The Importance of Strategy

The above-listed forms of risk are in no way exhaustive of all the ways risk can affect an investment’s outcome, but rather they aim to serve as evidence that all investments carry risk in some form, and are thus speculative in unique ways. Even the most risk-averse individual, who feels safer keeping their money under the mattress and out of the markets, faces a loss of their money’s value with time in the form of inflationary risk. So if all investments are subject to risk, and are therefore speculative in some form, what makes one asset better than another?

The best answer to the question is that it depends. It all depends on the nature of the asset and how it trades, but more importantly, the type of reward-to-risk ratio one is prepared to take. To make this point clear, let’s look at two investment scenarios using an asset we are all familiar with as an example: real estate. In scenario one, let’s assume we are a successful investor looking to acquire a property with cash, with the intention of renting it. In the minds of most people, this would undoubtedly qualifies as a bonafide investing activity with minor risk or downside. Now, let’s say in scenario two we are looking to buy the same property, but this time lacking the funds, we purchase with a minimal down payment for the purpose of “flipping the property”. This would undoubtedly be regarded as speculation, or at worst, a gamble. So why the difference? After all, the asset still remains the same in both scenarios.

This is true, but to properly answer the question, let’s first look at the asset type. Real estate, as we previously discussed, is an asset that is not uniform across the board, and is therefore difficult for a seller to transfer ownership quickly and easily at any given moment should the need arise. This unfortunately, is the nature of the asset. What this means in scenario two is that we’re highly exposed to liquidity risk if we’re unable to sell the property in time, in addition to the risk of using borrowed money (or leverage), making us prone to a default, and losing the property altogether. In the end, the primary difference is that although we are not void of risk in scenario one (e.g., the risk of income loss from a vacant property if we do not find a renter), we assume less overall risk than what’s present in scenario two, with the trade-off being a potentially lower reward for lower risk than is possible in scenario two.

Summary

In summary, it is important for the sophisticated investor to understand that speculation involves calculating risk and conducting research before entering a financial transaction. A speculator buys or sells an asset with hopes of having a bigger potential gain than the amount he risks. A speculator takes risks knowing that the more risk he assumes, in theory, the higher his potential gain. However, he also knows that he may lose more than his potential gain. In contrast, gambling involves a game of pure chance. Generally, the odds are stacked against gamblers. When gambling, the probability of losing an investment is usually higher than the probability of winning more than the investment. In comparison, gambling has a high risk of losing the investment.

The over-the-counter forex market, like the futures market preceding it, faces its chorus of cynics that broadcast it as a risky investment suitable only for gamblers and careless risk-takers. But it is important to note, just like all other investment assets, it carries a reward-to-risk profile unique to its market and asset type. What is more important than the market or the asset type, is determining how a particular investment and risk management strategy employed meets one’s overall portfolio goals through the careful management of the reward-to-risk ratio. We shall further explore this topic in future posts. Following links provide some more information on the topic.

Read More: The Reality of Investment Risk

http://www.finra.org/investors/reality-investment-risk#sthash.3ezqTfTW.dpuf

Read more: Risk Definition | Investopedia http://www.investopedia.com/terms/r/risk.asp#ixzz3tTi0EeNW

Read More: What is the difference between speculation and gambling?http://www.investopedia.com/ask/answers/042715/what-difference-between-speculation-and-gambling.asp#ixzz3tTh6e1jk

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