Man, it is said, lives on hope. But, hope is only a necessary condition for life, but not sufficient. There are many other materialistic things that he needs – food, clothing, shelter, etc. And, like his hope, his needs too keep changing through his life. To make things more uncertain, his ability to fulfill the needs too changes significantly. When his current ability (current income) to fulfill his needs exceeds his current needs (current expenditure), he saves the excess. The savings may be buried in the backyard, or hidden under a mattress. Or, he may feel that it is better to give up the current possession of these savings for a future larger amount of money that can be used for consumption in future.
In contrast to the above situation, if the amount available for current consumption is less than the current needs, he has to engage in negative saving, or borrowing. The funds thus borrowed may be used for current consumption. But, the lender of the money who forgoes his current possession and hence its consumption will ask for more than what he has lent. That is. the borrower should be willing to pay more than he has borrowed.
This trade off between the amount available for present consumption and future consumption is at the heart of all savings and investments. The ratio between the amount of current consumption that can be exchanged for a certain future consumption is called the pure or risk-free rate of interest or pure time value of money. This relationship is influenced by the forces of supply and demand and is determined in the capital markets. If foregoing 100$ of certain income today gives a certain income of 104$ after one year, the pure rate of exchange or pure rate of interest is said to be 4 percent.
The pure rate of interest referred to above is a real rate as it is based on two amounts of money that are fully certain. If the lender expects the purchasing power of money to fall during the time he lends money, he expects, in addition to the pure or risk-free rate, an amount to compensate him for the fall in the purchasing power of money. If the realization of the future amount is uncertain, he will expect much more and such excess is called the risk premium.
Keeping all the above in view, it can be said that an investment is an agreement for a current outflow of money for some period of time in anticipation of a future inflow that will compensate for the changes in the purchasing power of money, as well as the uncertainty relating to the inflow of the money in future. This understanding describes well all the possible investments, like stocks, bonds, commodities or real estate by all classes of investors like individuals, institutions, governments, etc. In all these investments, the trade off is between a known amount that is invested today, in return for an expected amount in future. While the amount being invested is certain, as it is now in our hands or rather is going out of our hands, the expected future inflow carries with it uncertainties regarding its realization and its real worth will be known only when it is due for realization.
Are all Investments Speculative?
We know that investment means sacrificing or committing some money today in anticipation of a financial return later. The investor indulges in a bit of speculation as to how much return he is likely to realize. There is an element of speculation involved in all investment decisions. It does not follow though that all investments are speculative by nature.
Genuine investments are carefully thought out decisions. They involve only calculated risks. The expected return is consistent with the underlying risk of the investment. A genuine investor is risk averse and usually has a long-term perspective in mind. Each person seems to have made carefully thought out decision and each has taken only a calculated risk.
Speculative investments on the other hand are not carefully thought out decisions. They are based on rumors, hot tips, inside dopes and often simply on hunches. The risk assumed is disproportionate to the return expected from speculation. The intention is to profit from short-term market fluctuations. In other words, a speculator is relatively less risk averse and has a short-term perspective for investment.
So, an investment can be distinguished from speculation by (a) the time horizon of the investor and (b) the risk-return characteristics of the investments. A genuine investor is interested in a good rate of return, earned on a rather consistent basis for a relatively long period of time. The speculator, on the other hand, seeks opportunities promising very large returns, earned rather quickly. In this process, he assumes a risk that is disproportionate to the anticipated return.
There exists a clear-cut demarcation between investment stocks and speculative stocks. The same stock can be purchased as a speculation or as investment, depending on the motive of the purchaser. For example, the decision of an investor to invest in a stock is considered as a genuine investment, if he seems to be interested in a regular dividend income and prospects of long-term capital appreciation. However, if another investor buys the same stock with the anticipation that the share price is likely to raise very quickly and gain from the rise, such decision will be characterized as speculation.
Are Investment and Gambling the Same?
Gambling is defined as an act of betting on an uncertain outcome. Since the prospective return on investment is uncertain at the time investment is made, one may say that there is an element of gambling involved in every investment. This is particularly so in the case of those investments in respect of which little information exists at the time of investment decision. However, genuine investments cannot be labelled as gambling activities.
In gambling, the outcome is largely a matter of luck; no rational economic reason can be given for it. This is in contrast to what we can say about genuine investments. Unlike investors and speculators, the gamblers are risk lovers in the sense that the risk they assume is quite disproportionate to the expected reward. Though the pay-off, if won, is extraordinary, the chances of winning the bet are so slim that no risk averse individual would be willing to take the associated risk.
It should, however, be noted that a clear demarcation between investment, speculation, and gambling is not always easy. Often it becomes a matter of degree and opinion. Aggressive investors are likely to decide on investments based, among other things, on their speculative and gambling instincts more than the defensive or conservative investors do.