Should You Invest in Speculative Investments?

David K. MacLeod, CFP®, CFA

Perhaps you got a hot stock idea at the recent family barbecue. Or maybe you have a desire to add some excitement to your investment portfolio. Should you invest in speculative investments? And what are speculative investments anyway?

A speculative investment is a type of investment with a high risk of total loss and the possibility of a significant gain. Speculative investments exist in many asset classes, from real estate to individual stocks.

Benjamin Graham, the famous investor and teacher of financial analysis, wrote in the first chapter of his book The Intelligent Investor about distinguishing between an investment and a speculation. He wrote: “An investment is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Graham preferred a long-term approach that avoided “hot” stocks promising quick profit. He acknowledged that some speculation is inherent in common stocks over the short term. He also understood that many so-called hot investments don’t maintain the streak for long.

A key part of distinguishing between investment and speculation lies in analyzing and understanding the underlying fundamental value. In this article, I’ll caution against unintelligent investment speculation that comes in various forms.

Stock Market

The stock market can be viewed as speculative or not, depending on your time frame. There’s an adage that applies here: Time is the friend of the good business and the enemy of the mediocre. No one knows what tomorrow may bring; however, over the long term, a good business can weather many storms and bounce back.

Stocks can be speculative in the short term but safe over the long term, and diversifying across many stocks reduces the risk of loss over the long term. The longer your expected time frame, the more likely you’ll get a good outcome in inherently risky investments like stocks.

An analysis of the S&P 500 since 1926 found that over one-year holding periods, stocks had a positive return 71% of the time and outpaced inflation 68% of the time. However, extending the holding period to 10 years led to positive returns 95% of the time and beat inflation 90% of the time. Extending further to 20-year holding periods led to a perfect record of positive returns and beating inflation.

Individual Stock Concentration

We think making a concentrated purchase of an individual stock of more than 5% of your total portfolio is speculative. It’s true that concentrated holdings have made some people millionaires and billionaires (Microsoft’s Bill Gates), but it’s also true that thousands of individual company stocks have suffered catastrophic losses.

According to a JP Morgan study of the U.S. stock market, since 1980, 40% of all stocks have suffered a permanent 70%+ loss from peak value and have never recovered.

Many of these losing stocks are names you would recognize, including Goodyear Tire & Rubber, New York Times Co., Trump Hotels & Casino Resorts, Blockbuster, Macy’s, AIG, Dell Computer, Sprint, and many U.S. airlines. About 57% of technology companies have experienced such a catastrophic loss. The stock market has increased overall because the gains from the outlier winners more than offset the massive losses of the losers.

A CEO may be excited about the future of their company and convince you that buying their stock is almost risk-free. But a lot of factors outside of their control can derail their plans, including government policies, expansion by competitors, intellectual property infringement, commodity price swings, and fraud.

Leverage

Investing with borrowed money is speculative, whether on margin with a broker or with any other kind of debt. For example, say you purchase an income-producing real estate property in Orange County, CA, with a 10% down payment. So, 90% of the purchase is funded by a mortgage loan.

If your real estate value declines by 20%, your capital loss is massive. Not only have you lost all your principal, you may now owe the bank 12.5% more than the value of your property.

If the fundamentals of the property are good, you have a chance of recovering. But, even in the best case, you will probably have to wait for the market to turn around. In the worst case, you may lose your property and have an unhappy bank to deal with.

Big Mistakes

Many smart and successful people have made big mistakes because of speculations. Mark Twain said: “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”

Sadly, Twain knew this from personal experience. According to Michael Batnick’s book Big Mistakes, Twain lost 85% on the Oregon Transcontinental Railroad stock, and he lost $5 million (in today’s dollars) on a start-up typesetter company.

It’s important to match your goals and time frame with appropriate asset classes and specific investments. Any funds invested for the goal of financial independence should avoid speculation. Diversification is important because you can’t know beforehand with 100% certainty which issues are going to offer higher returns and which will be a loss.

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