I was talking with a group of economists and finance professors lately and we were trying to determine what are the characteristics between investments, gambles, speculation and insurance. Using the dictionary definitions of the terms provides surprisingly little insight to real world cases.
Consider the following example:
Take an option that is well out of the money - that is an option that is highly unlikely to ever have any economic value. Take an option that gives the holder, the right but not the duty, to buy Canadian dollars at the price of $2 US each that expires in 3 years. Considering the Canadian dollar is currently worth 94 cents USD, this option is practically worthless because the chance the Canadian dollar exceeds $2 US between now and three years from now is in the ballpark of 1 in a million. You could pick up thousands of these options for almost nothing.
Is buying these options an investment or a gamble (or both.. or neither)? They clearly appear to be a gamble as they are a lot like a lottery ticket - 999,999 times out of 1,000,000 or so they don't pay off and you lose the money you pay for them. But that one time in a million, you hit the jackpot. But what if you believed the market was underestimating the risk, such that the expected value from purchasing these options is positive. Would it then become an investment instead of a gamble? Even if these options paid off only 2 or 3 times out of a million? Can something be both an investment and a gamble?
It would also clearly seem to be speculating - the person buying the option is speculating that the Canadian dollar has a better chance of an astronomical rise than the market is allowing for. But by this definition, buying any asset that has downside risk is speculating. Would we say that someone who buys their house instead of renting is speculating? What distinguishes investing from speculating.. and why does the term speculating have a negative connotation while investing is looked upon favorably?
Buying these options may be a gamble, but currency options are used by various economic actors as a form of insurance, as large short-term currency fluctuations can be deadly for firms that earn their income in one currency and pay their expenses in another - the problems the Toronto Blue Jays had in the late 1990s is a prime example of this. But can something be both a gamble and a form of insurance? It seems counterintuitive to many, with Ned Flanders being a notable exception:
Consider the following example:
Take an option that is well out of the money - that is an option that is highly unlikely to ever have any economic value. Take an option that gives the holder, the right but not the duty, to buy Canadian dollars at the price of $2 US each that expires in 3 years. Considering the Canadian dollar is currently worth 94 cents USD, this option is practically worthless because the chance the Canadian dollar exceeds $2 US between now and three years from now is in the ballpark of 1 in a million. You could pick up thousands of these options for almost nothing.
Is buying these options an investment or a gamble (or both.. or neither)? They clearly appear to be a gamble as they are a lot like a lottery ticket - 999,999 times out of 1,000,000 or so they don't pay off and you lose the money you pay for them. But that one time in a million, you hit the jackpot. But what if you believed the market was underestimating the risk, such that the expected value from purchasing these options is positive. Would it then become an investment instead of a gamble? Even if these options paid off only 2 or 3 times out of a million? Can something be both an investment and a gamble?
It would also clearly seem to be speculating - the person buying the option is speculating that the Canadian dollar has a better chance of an astronomical rise than the market is allowing for. But by this definition, buying any asset that has downside risk is speculating. Would we say that someone who buys their house instead of renting is speculating? What distinguishes investing from speculating.. and why does the term speculating have a negative connotation while investing is looked upon favorably?
Buying these options may be a gamble, but currency options are used by various economic actors as a form of insurance, as large short-term currency fluctuations can be deadly for firms that earn their income in one currency and pay their expenses in another - the problems the Toronto Blue Jays had in the late 1990s is a prime example of this. But can something be both a gamble and a form of insurance? It seems counterintuitive to many, with Ned Flanders being a notable exception:
Neddy doesn't believe in insurance. He considers it a form of gambling.I would love to hear your thoughts - how can we distinguish between investments, gambles, speculation and insurance?
Comments
Investment = Gamble = Speculation. Any differences someone attributes to the three will, however, tell you a lot about that person, e.g., risk tolerance, core values, opinion on market efficiency, opinion of their own decision-making skills, etc.
In an efficient market, those currency options (Moffatt’s example) should be priced such that in the long run it’s a break even proposition. It would be like getting 5 to 1 odds on the roll of a die. For every 5 times you lose $1, you win once for $5.
Insurance is a specific application of Investment/Gambling/Speculation.
The only potential difference I can think of between gambling and speculation is that gambling often doesn’t change the odds but speculation always does, if only infinitesimally, by providing information to the market. One could restrict gambling to fixed odds but that would not be common, so I would say this transaction alone is gambling and speculation. If combined with an offsetting position, say a real trade, it can then be insurance and a hedge, the difference is which a hedge can be profitable while insurance can only offset a loss. The differentiating factor between speculation and investing is investing provides an income flow while holding it. This may be restricted to interest and dividends or relaxed to earnings but in their absence is only a speculation. A liquidation value is more or less speculative.
Great post. This is one thing I think economics does a poor job distinguishing. The problem is the false dichotomy between “rational investment” and “irrational speculation”. Both are gambles in-so far as they involve risk (a non-certain return), but to an economist, “investment” is typically defined based on fundamentals of the market whereas speculation is based at least in part on predicting future prices, future market conditions on some subjective criteria usually based on the belief that OTHERS’ speculation will have an effect on the market. I’ve always taught in my class, that such speculation, while “irrational” in aggregate could actually be quite rational at the individual level in so-far as there is credible belief by an individual that aggregate speculation / bubbles are forming one way or another. I run a bubble-formation / popping game in my class some semesters and speculators are often able to ‘beat the market.’ It is a gamble, but I don’t see why it’s necessarily “irrational.” So, in that sense, speculation and so-called “rational” investment are one and the same.
I am currently studying investment psychology and based on my research believe that investment to some extent is the linked to gambling and speculation.
This is based on that some investors will only gamble ie guess what investments to take on and in the event that they are good investments, this reinforces their investment decision making to always gamble and like in gambling people can win big and also lose big.
On the other hand investment is also linked to speculation as some investors rely on speculation in their decision making process and will only invest in speculated stocks. The reason why it works is speculation causes some changes in the stock market be it positive or negative.
Insurance is that reasurance people need in the event of a mishap or accident happening. they dont anticipate the event occuring and dont go out of their way to promote the event (its unwanted)unlike in investment were a positive outcome is desired.
Any displine that deals and is dependent on lots of future variables has to have some level of gambling, speculation and ofcourse covering your initial capital if any of those variables goes haywire.The level of research and knowledge of what you want to achieve(objectives)will determine the classification.General objectives are :Growth,Liquidity,Income,Safety and less taxes.How you balance those in your decision making should be able to help you classify an investment, a speculation and a gamble within a reasonable holding period.
Here are some different defintions that I came up with:
Gambling=creation of an artifical risk for entertainment purposes. The outcome of the game is not known but the probabilities of the outcome are known and can be calculated before any wager is placed. The time frame from when the wager is placed until the game is resolved is almost always very short (seconds to days).
Insurance=paying a premium to protect against an unfavorable event under conditions of uncertainty. Neither the outcome nor the exact probabilities of a natural event are known before the premium is paid; insurers usually price premiums based off historical analogous samples and assume those data will approximate future conditions (as under conditions of uncertainty the exact probability is never known beforehand). The time frame on insurance products is usually measured in years — long term time horizon.
Investment=purchase of an asset based upon an estimate that it’s total return under current conditions is favorable. Usually investors have a long term time horizon.
Speculation=purchase or sale of an asset based upon a belief that conditions will change significantly in the near future. Usually speculators have a short term time horizon.
Also, the point of another commentor was very good, in games of chance a wager doesn’t have an effect on the odds of the game. In the financial markets an additional speculative position alters the risk/reward ratio on that position.